Rich and Richer, Dumb and Dumber
April 16, 2013
No, we're not talking about the inequities of our economic class structures, nor the 1994 comedy starring Jim Carrey and Jeff Daniels with bad hair cuts. Rather, the topic is about investors, and how on average, they repeatedly shoot themselves in the foot, market cycle after market cycle. In their attempt to ease their fear and embrace their greed, they historically do the wrong thing at the right time, or vise versa.
Dalbar, the stock market research company, recently announced their Investor vs. Market research data (Dalbar.com). They found that over the last 20 years, the average return of all stock mutual fund investors was 4.25%, or only about half of the 8.21% annualized return enjoyed by the S&P 500 Index over that same time period. That means for every dollar an average investor invested, it grew to $2.30. Had they just invested in an S&P 500 Index fund and held tight, their $1.00 would have grown to $4.85. That's not including additional superior returns they could have earned by owning multiple equity asset classes in proper proportions, and rebalancing along the way.
Why do investors underperform the market so dramatically? Dalbar gives us further clues as to how these great differences in returns can occur. They track mutual fund flow data, and noted that January 2013 was the first month that investors were net buyers of stock mutual funds since the current bull market started in March 2009. That's right. For almost four years, as the market has continued to move in a sometimes erratic yet upward direction, investors were net sellers of equity mutual funds. Only now are they venturing forth and buying again. Talk about buying high and selling low. That phrase is often used as a punch line in the investment business. But as you can see, in the real world experience, it is unfortunately a true statement.
Emotional decision-making, therefore, explains why the average stock mutual fund investor underperforms the market averages. If you look back over the last 20 years, you can see the strong bull markets of the late nineties, mid 2000's and the last few years, along with the deep bear markets of 2000-2002 and 2008-09. It can be easily understood how fear and greed may have controlled many investors' actions. Our clients, of course, have not played this game. As a whole, they were in the market with their full equity allocation at the end of the '08-'09 bear market, and were able to recoup their portfolios' drawdowns in approximately two years. Being disciplined, with a view on maximizing long term returns, has allowed gains in what has been the most difficult dozen years since the 1930's. That's how you become rich and richer. And now you know how not to become dumb and dumber.
Too Much Bonding Time
When the above referenced investors were net sellers of equity funds during the last few years, guess what they were buying? Bonds. That's right, they were charging into what they believed were safer, more predictable investments. Undoubtedly, you have heard that bonds offer more risk now than they have in some time. That's because interest rates do not have a lot of room to go down, and as soon as the Federal Reserve decides to stop enabling low rates, there is plenty of potential for upward movement in rates. That's when the secular bond market rally, that has been rewarding long term bond holders for close to four decades, may finally come to an end. When, not if, that happens, bond and bond fund holders will see that bonds have a risky side, as well. How much risk? Review the data below:
Even a bond with an innocuous 5 year maturity can cause some real damage to a portfolio with a two or three point interest rate increase. Those same increases to longer term bonds can decimate a portfolio that for decades has looked to these types of investments as "conservative" holdings. In order to best protect our clients' portfolios from this volatility, we have always owned short to intermediate bond funds and two years ago we made the decision to shorten our average maturity to less than three years. We recognize that just like no bell was rung to start the bull market in stocks in 2009, no bell will be rung to start the bear market in bonds. We would much rather be in a shorter term maturity position before the "fun" starts.
Don't Just Take Our Word For It
Several times over the last few years we have given our opinion, backed by academic research, that passive investing is superior to active investing, especially when taking into consideration the higher fees, portfolio turnover costs and the efficient distribution of market information. You may feel we have been jaded due to the fact we use passively managed equity asset classes as building blocks for our clients' portfolios. But a recent news item from a global giant seems to back up what we have been saying.
In March it was made public that the California Public Employees Retirement System's (CalPERS) investment committee is determining whether they should eliminate using all active managers and hire only passive ones. *InvestmentNews "Largest pension fund considers dumping active management" 3/21/13 The largest pension fund in the US already has more than half of its money passively managed. Apparently their actively managed assets have done so poorly as to potentially turn CalPERS into a 100% passive portfolio. Throughout the US, actively managed equity funds still have about twice as many assets as passive. However, over the past decade, investors have placed over $1 trillion in passive funds as opposed to only about a quarter of that amount into actively managed funds. So our clients can feel pretty good about their intelligent decision to "go passive" years before one of the wealthiest and most visible institutional investors potentially makes the same decision. Maybe taking our word for it wasn't such a bad idea after all.
The broad stock market jumped out of the 2013 gate with a bang and continued that up trend throughout the first quarter. Once Washington pieced together an unimpressive last minute "fiscal cliff" package, the lid was taken off of equity prices. All domestic equity asset classes except Real Estate enjoyed double digit returns for the period. Value classes modestly beat Growth. Small and Large had similar returns. Income classes struggled to stay positive, as interest rates had slight increases. Internationally, developed markets had more modest single digit returns, while Emerging Markets showed relative weakness.
The large reserves of cash, which have been building since the '08-'9 bear market, was the impetus to the strength in the US markets. With interest rates at anemic levels and threatening to increase, investors have apparently decided that potential returns of equities are worth the increased volatility. The US economy continues its slow growth ways. Unemployment is very slowly decreasing. Corporate profits are continuing to grow, albeit at very modest rates, partly due to year end legislation. The housing market is finally climbing out of the doldrums, with certain parts of the country actually enjoying healthy year over year comparisons. Internationally, Europe is still putting out small (country specific) fires, as they appear to be lagging the US recovery by two or more years. The major debt delevering of England and most European countries continues.
Most domestic major market equity indexes hit new highs during the first quarter, causing many to question whether the market is overvalued. Remember that valuation and market levels are not necessary connected. For instance, the S&P 500 is at a new high, but its valuation is no where near the valuation highs of 2000 or 2007. In addition, the economy has not ramped up growth in this cycle, which is often the impetus for the proverbial "irrational exuberance" phrase coined by former Fed Chairman Greenspan in years gone by.
It would be naïve to expect the current strength in the market to continue without experiencing either a "pause that refreshes," if not a full blown market correction. Either should not only be expected but viewed as potentially healthy for the market. Our advice would be to not become enamored with quarter by quarter performance, but rather look to the long term return that your portfolio was designed to deliver. That return demands some degree of volatility. We have experienced very positive volatility recently, but remember that positive volatility has a flipside. Be assured that the diversification that your portfolio enjoys is based on Modern Portfolio Theory's empirical proof. Trust that over time the efficient use of risk to generate your portfolio's return is the recipe for superior long term results.
The next time you hear from us will be after April showers, May flowers and the beginning of summer. We'll check back to see if the markets have continued their warming trends or have gone in a chillier direction. In the meantime, get outside and enjoy all the beauty around you.
Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC