Monday, May 12, 2014

Why Do So Many Investors Underperform?

This previous post focused on how investors do compared to the mutual funds they own.

Not very good.

Well, not surprisingly, they also don't do particularly well against the S&P 500.

20-year annualized returns ending in 2012
- Average Investor: 2.3%

- S&P 500: 8.2%

A separate study by Dalbar indicated a similar outcome for the 20-year period ending on December 31, 2013.

20-year annualized returns ending in 2013
- Average Investor: 5.02%

- S&P 500: 9.22%

The 30-year relative returns look, in a similar fashion, well, terrible.

The discrepancy between the studies probably isn't just down to the slightly different time frames. Each study inevitably has different methodologies, limitations, and imperfections. From this Wall Street Journal article:

Louis Harvey, Dalbar's president, says, "We have comfort that our method is reasonable," although he adds that "every method has its flaws."

Some experts think the Dalbar numbers overstate the gap. Both of the above suggest a meaningful gap. Others suggest a somewhat smaller gap in performance.

Yet they all reveal, even if to varying degrees, some meaningful level of underperformance.

What should matter less than the specific gap in performance is what it says about investor behavior. Well, a big driver of investor underperformance, to put it only somewhat too simplistically, is the tendency to chase what's recently been hot and selling what's not.

Basically buying what has already been bid up and selling what's cheap. A great way to guarantee less than stellar results and, unfortunately, a too reliable pattern of behavior.

Investors with long enough time horizons would benefit from less action. Attempts to jump in and out at just the right time are surely well-intentioned but often misguided. Many think they can successfully navigate in such ways; far less actually do. Selling when the headlines indicate trouble lies ahead -- sometimes even serious trouble -- and stock prices have moved in accordance with such news is another way to absolutely minimize returns.* John Bogle, not surprisingly, says it very well:

"The way to wealth, it turns out, is to avoid the high-cost, high-turnover, opportunistic marketing modalities that characterize today's financial service system and rely on the magic of compounding returns. While the interests of the business are served by the aphorism 'Don't just stand there. Do something!' the interests of investors are served by an approach that is its diametrical opposite: 'Don't do something. Just stand there!'"

Some of this comes down to the tendency to chase performance. In effect, this behavior leads to buying high. Chasing performance usually reduces returns. In addition, market participants tend to be sellers when things seem to be (or are) going very wrong. Well, that's usually when stocks are cheap. The pattern of buying high and selling low -- though, of course, intending to do otherwise -- leads to a predictable outcome.

Unfortunately, it's not just individual investors who are susceptible to actions that end up hurting results:

"Individual investors have long been accused of being a lagging indicator, pouring money into areas of the market after they've seen their biggest run-ups. But that's a mistake not limited to just retail investors, but also often made by pensions and endowments managing much larger pools of money, according to insiders."

Also, at least if the following is any indication, the long run performance of most actively-managed mutual funds is hardly impressive:

% Actively-Managed U.S. Equity Funds that Outperform
- Over 20 Years: 20%

- Over 30 Years: 14%

- Over 40 Years: 12%

Pros aren't necessarily immune to buying what's hot or what currently has the most compelling story to tell. Some money managers feel pressure to perform on a shorter term basis and the necessity to buy what's currently in vogue, for example. They may also be prone to sell shares of a struggling business (or be forced to sell due to fund investor redemptions) at a price that reflects the troubles. This is often done with the idea (or hope) that it will somehow be possible to buy back in at an attractive price if/when prospects improve.
(Though, of course, there are also many capable money managers who have the discipline to avoid this sort of thing. Now, at least in theory, it shouldn't be impossible to figure out who has a sound long-term investing approach, does a good job of balancing risk and reward, and has a track record to back it up. In practice, unfortunately, it's a bit tougher to figure out which specific funds will do well many years into the future.)

This paper looks specifically at hedge fund investor performance from 1980-2008:

"Our main finding is that annualized dollar-weighted returns are on the magnitude of 3% to 7% lower than corresponding buy-and-hold fund returns. Using factor models of risk and the estimated dollar-weighted performance gap, we find that the real alpha of hedge fund investors is close to zero. In absolute terms, dollar-weighted returns are reliably lower than the return on the Standard & Poor's (S&P) 500 index, and are only marginally higher than the risk-free rate as of the end of 2008.The combined impression from these results is that the return experience of hedge fund investors is much worse than previously thought."

Keep in mind that this has had -- and is likely to continue having -- a big impact on institutional investors (pensions, foundations, educational institutions). Why is that? Apparently, at least 60% of the money invested in hedge funds these days comes from institutional investors.**

The paper then later adds that, once again, the subpar performance "seems predominantly driven by investors' return-chasing behavior."

Logically, it seems reasonable to wonder if one repercussion of all this might be that a number of pensions and other institutional investors will, as a result, find it difficult to fund their liabilities down the road.

Some of the shortfall no doubt comes down to promising too much. Yet the study above more than suggests that part of the problem will be investment policies, practices, and behavior. Meanwhile, a large proportion of investable funds are going where some of the highest frictional costs exist. With roughly 60% or more of hedge fund assets coming from institutional investors, these frictional costs are now deeply embedded in the system. So some pensions and the like may not be able to meet their long-term obligations but those who directly manage a bunch of that money -- the hedge funds -- certainly seem likely to come out just fine. In fact, the current system seems almost designed to produce just such an outcome.

Now, it's hard to fault the hedge funds, they're just going where the money is. Perfectly reasonable. It seems more about those institutional investors who choose to allocate capital this way yet are in a position to do otherwise.

In addition, at least if the above study is a mostly reliable indicator, too many what should be rather sophisticated investors behave in a way that's usually attributed to less experienced investors:

- Paying excessive fees.

- Frequent or, at least, inopportune buy and sell behavior -- in part, the result of short-termism, an illusion of control, and overconfidence -- that leads to unnecessary mistakes (and yet even more frictional costs).

- Chasing performance during the good times; selling during the tougher times; too little emphasis on margin of safety at all times.

- A focus on near-term and intermediate-term price action instead of intrinsic values -- considering the specific risks much of which is not quantifiable -- and how that value may change over time.

Among other things that generally hurt results.

So, if the study of hedge fund investor performance is even close to being correct, it means that the system in its current form surely isn't working all that well.

There are certainly some fine money managers, but that hardly guarantees the system as a whole is effective.

Even if performance was generally equal to the S&P 500 (instead of underperforming as these as these various studies suggest) there's no getting around the reality that lots of very smart people -- both those who manage funds along with the institutions that choose to invest their capital in these funds and other assets -- are engaged in these activities. If the outcome, give or take, merely matches a more passive approach, it begs the question whether that talent would be better applied elsewhere.

It's just hard to imagine how the current system is anywhere near optimal.

Now, as noted above, it's tough to fault those who choose to work in such a lucrative field. That doesn't mean the compounded negative impact of the current system over time isn't very real.

The many capable individuals who work hard to deliver superior investment results -- though often appear to be not doing so -- might just be better allocated to more productive activities.

Again, it's not as if any of these studies should be considered somehow absolutely correct. Given the inevitable biases -- and at least somewhat flawed methodologies -- that likely exist, some skepticism is warranted.

Yet, even though surely less than perfect, these results shouldn't just be discounted or ignored. It would take some contorted logic or clever marketing to do so. These studies at least suggest there's an opportunity for market participants (professional and non-professional) to improve results with some wise changes to behavior.

"To kill an error is as good a service as, and sometimes even better than, the establishing of a new truth or fact." - Charles Darwin

"...Warren and I are better at tuning out the standard stupidities. We've left a lot of more talented and diligent people in the dust, just by working hard at eliminating standard error." - Charlie Munger in Stanford Lawyer

The importance of eliminating error (or "tuning out the standard stupidities..." ) is naturally relevant to both the individual investor and the institutional investor.

Maybe, with a concerted effort over many years some of the more obvious systemic defects as well as well as the behavioral biases and tendencies that lead to unnecessary errors and frictional costs, will become at least reduced.

It's probably never going to be easy for the bulk of participants to outperform the market as a whole, but that doesn't mean the rather lousy long-term results -- experienced by both individual and institutional investors -- noted above are an inevitability.***

Still, history suggests changes will come slowly if at all.

Overcoming at least some of the behaviors that lead to poor investment decision-making alone is an awfully tough thing to do.

Even in the best of circumstances, things like cognitive bias play a big role in investor performance. Too many kid themselves that they're not susceptible to the kind of psychological forces that can hurt long-term results.

They pretend it's the other guys problem.

They imagine they'll be the coldly rational ones when it counts.

Well, fewer actually act in such a way when it matters. The above results do indicate a pattern of buying high and selling low. In other words, too many act greedy when others are greedy and fearful when others are fearful. This is, of course, pretty much the opposite of what's desirable over the longer haul. Many participants, beforehand, probably believed they'd behave otherwise; that they'd be the ones who acted sensibly during market extremes. Well, at least they did before things really started to go south; at least they thought they'd see the prevailing exuberance (and premium prices) for what it really was before they became caught up in it themselves.

Generally, the only way to buy a good asset at a nice discount to intrinsic value is when fear is pervasive. Similarly, the chance to sell at an attractive price will usually be when exuberance and greed dominate the psychological landscape. Making decisive and mostly correct decisions when the economic storm is most intense and the headlines are scariest -- whether company specific or more macro in nature -- is never easy. Watching something bought at a price that seems cheap become cheaper on a quoted basis -- even if, with the benefit of hindsight, it turns out to only be a temporary drop -- is never easy. On the other end of the spectrum, seeing others profit -- making what seems like the quick and easy money -- during exuberant market environments is tough for even very smart participants to ignore.
(Now, especially when it comes to individual stocks, this also requires knowing the difference between temporary -- even if serious -- but fixable problems and, well, maybe terminal problems.)

So it's not likely that a large proportion of those who put money at risk in the equity markets will change behavior and, as a result, improve results. That doesn't mean the individual investor -- whether a professional or not -- can't at least learn to overcome some of the most obvious mistakes that get made. The gap in performance could at least be closed somewhat with some systemic changes and with altered behavior from professional and non-professional market participants.
(If nothing else via changes that lead to reduced frictional costs.)

It's a real opportunity even if potent forces -- some psychological, some policy, some purely economic -- work against the needed changes.

So yeah, realistically, meaningful improvements will be difficult to come by.

Difficult is not the same as impossible.

This could, all things being equal, make it more difficult for any one participant to outperform the market. Well, to me, equity markets would be much improved if participant returns were mostly the result of per share intrinsic value increases over long time frames, and less from clever trading around near-term price action.

That just might dial back the prevalence of casino-like activities, and bring to the forefront effective capital formation and allocation.

Equity markets should, first and foremost, effectively, and with the lowest possible frictional costs, facilitate moving capital to where the real economy needs it.

They should be designed to serve longer term oriented investors instead of those who mostly benefit from -- via either fees, commissions, or both -- increased market activity and asset gathering regardless of investment outcome.

They certainly shouldn't be designed to encourage making various kinds of short-term bets.

Adam

Related posts:
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

Related articles:
Finding the Right Mutual Funds
The Performance of Mutual Funds
Don't Bet on Luck, Active Management Underperforms
Jack Bogle's market advice: "Don't do something; just stand there"

* Not to be confused with stubbornly holding onto an a bad investment that's dropped substantially. That's a great way to achieve lousy investment outcomes. Sticking with a losing proposition often leads to even bigger losses. It's just that even the soundest long-term investments will see price action that has little to do with long-term prospects and core economics. A sound investment process requires, in part, that assets only be bought when sufficiently mispriced on the low side. The investment process also requires learning to make temporarily reduced prices of a good asset your friend (or at least not making it your enemy by selling into the negative price action).
** The same paper does a good job of explaining why measuring hedge fund results from inception "is a poor representation of the return of actual investors". The reason? Investors add capital in "widely uneven bursts". So, by dollar-weighting over time to account for these bursts, they get a more meaningful measure of actual investor results. As it turns out, returns are much reduced when adjusted for this. The adjustment is meant to better reflect the actual returns on the amount of capital that's invested and when it is invested. So the longer term results, when measured from inception, appear a whole lot better than the results of investors when dollar-weighted over time. One can choose to blame the fund investors for their poor timing, the fund managers, or both, but the actual results, either way, appear to be just not good if this paper is any indication. Keep in mind that hedge funds now manage something like $2.5 trillion -- up from $38 billion in 1990 -- and have underperformed the S&P 500 over the last five years. Now, five years isn't really a long enough time frame to judge relative performance. Still, I think it's fair to say that it'll likely be a whole lot more difficult to outperform with $ 2.5 trillion in assets to manage than it was when the industry had far fewer assets to manage. The hedge fund industry, if nothing else, has successfully gathered lots of assets. Will future results become a further victim of that success? We'll see. Who knows, maybe the longer term investor results will end up being just fine but it at least seems that, all things considered, some skepticism is warranted. Some make the argument that the goal of hedge funds was never to outperform an index like the S&P 500. That they're, instead, about managing risk. Well, managing risk is certainly a big part of effective capital allocation. Whether a satisfactory risk and reward trade off will be achieved by the vast majority of hedge fund investors, considering the frictional costs and other factors, also seems to deserve some skepticism. This article, which covers findings from a book by Simon Lack, suggests returns are actually far worse than they would appear especially if "survivor bias" is considered. In other words, since only surviving hedge funds report results, the overall performance seems better than it is. Adjusting for this bias, hedge fund investor returns, from 1998 through 2010, were negative $ 308 billion while the fees collected by hedge funds were $ 324 billion. Separately, this offers an interesting argument that it is pension accounting itself creating an incentive to continue investing in hedge funds when it might otherwise not make sense.
*** Naturally, returns for participants, in aggregate, can only be equal to the market returns minus frictional costs of all kind. I'd add that it seems about time to put to rest the idea that it's only the individual investor who is susceptible to the kind of behavior -- as noted above in the main section of this post -- that is detrimental to results. Whether we are talking about individuals, institutions, or the fund managers, it appears that long-term underperformance by a large proportion of participants -- even if it's to varying degrees -- is the norm.
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