“Investing is simple, but not easy.” – Warren Buffett
Anyone willing to do some research on how to invest will eventually find the relatively simple approach that most experts recommend to individuals. Like in Blackjack, let’s call this Basic Strategy:
- Start by determining the right mix of stocks, bonds, and other investments to hold based on your financial needs and goals. This mix is your asset allocation.
- Buy low-cost funds in the right amounts to make your portfolio match your target asset allocation.
- As your portfolio deviates over time from your target asset allocation, buy or sell investments to get your portfolio back to the right mix. This is called rebalancing. You don’t need to check your portfolio every day or week — quarterly or annually is perfectly fine.
- As you get older (or whenever your needs/goals change), adjust your target asset allocation to better match your current needs. Typically, this means slowly shifting towards bonds and cash, and away from growth investments, like stocks and real estate.
This strategy serves as the foundation for the service I provide for my clients. In fact, this strategy is very similar to what large, sophisticated investors do — institutional investors like the endowments at Harvard, Yale, and Stanford.
What’s interesting is what you don’t see up there:
- Pick stocks.
- Read the WSJ or NY Times for interesting investment ideas.
- Guess what Congress or the Fed will do next.
- Estimate how the economy will do next year.
Although appealing, these are not part of Basic Strategy for individuals. Why? Because they don’t really work.
The Unfortunate Evidence
It’s easy to tell that investors in aggregate do not follow Basic Strategy –whether it’s because they aren’t aware of it, they don’t accept it, or they have trouble sticking with it.
Mutual funds keep track of when their investors buy and sell their funds. With that data, researchers can calculate the return that those fund investors actually earned vs. what they could have earned by simply buying and holding. On average, investors have earned 1% per year less than the funds they buy.
Even Vanguard index funds — the very funds that typically attract disciplined investors — show a similar effect.
There are also numerous studies that look at brokerage account transactions to analyze the performance of individuals who pick stocks. Their conclusion? Stock pickers in aggregate do worse than the market average, and the more you trade, the worse your performance.
Why don’t investors learn to do better? It seems like investors are hurting themselves over and over, quite consistently. Here are a few theories.
For many investors, Basic Strategy is quite difficult to accept. The lack of constant action seems to be counter-intuitive. “What do you mean I should just accept what the market gives me? I can do better than that!”
If you don’t accept Basic Strategy, then you’re probably bouncing from one investment idea to another. It might work, but looking at the evidence above, the odds are seriously stacked against you.
To beat those odds, you really need to research and test potential strategies with a skeptical mind. Before I adopt an approach to improve on Basic Strategy and implement it for my clients, I want to see data that covers multiple market cycles. This means decades, not months or even a few years. Beating Basic Strategy is extremely difficult, so I require extremely convincing evidence to deviate from it.
Even if you accept Basic Strategy, one of the hardest things for investors is losing money. Conceptually, we all know that we need to risk losing money temporarily to earn higher returns over time. But understanding it in our heads is quite different than living through a down market like 2008.
When you see your portfolio balance shrink, it’s easy to reconsider your strategy. “Is this really the best strategy I could be following?” And if you decide to change your strategy in a down market, the change is almost always to take less risk. Which means you don’t buy to rebalance, or you may even sell.
Actually, I’m not just guessing. That’s exactly what investors do:
Fear of Missing Out
If we’re not nervous in a down market, then we’re likely fearful of missing out in an up market. When the stock market is up like the S&P 500 has been recently, the first thing you naturally do is check if your portfolio has kept up.
Since US stocks (S&P 500) have done so well over the last year or so, it’s probably been the best performing investment in your portfolio. Considering Basic Strategy holds a wide variety of investments, it should, by design, lag the S&P 500 in that situation. In exchange, when the S&P 500 is one of the worst investments, a diversified portfolio would beat it easily. This is the deal that we knowingly make by following Basic Strategy. Avoiding the biggest losses, even at the cost of missing the largest gains, improves your returns over time and is the primary benefit of diversification.
Understanding we can’t match the performance of the best investment over a year or two is quite different from experiencing it. We can’t help but think about what we could have done differently last year or the year before to earn those amazing returns.
At times like these, it’s very tempting to shift our portfolios toward investments that have done well recently. Looking at the chart above again, individual investors seem to do this consistently to their own detriment.
In contrast, sophisticated institutional investors approach investing with more discipline and seem to react less to short-term noise.
|1-Year Return||10-Year Return|
The endowments at Harvard, Yale and Stanford have all lagged the S&P 500 by a large margin over the last year. But none are considering increasing their holdings in US stocks just because it has done so well over the last year. In fact, they’re not making any drastic changes to their strategy since they are comfortable with the long-term strategy they already have in place. Looking at their 10-year returns (vs the S&P’s), it’s easy to see why.
What To Do
Based on the evidence, it seems like we’re just not wired to be good investors. So what can you do to resist your innate behavioral biases?
- Educate yourself to fully understand the investment strategy you’re using. This can help avoid the temptation to change strategies at the worst times. It will still be very difficult to be disciplined enough to stay the course.
- If you don’t want to manage your investments yourself, get help. Depending on the level of customization you need, here are a few options:
- Buy a target-date fund that has a simple version of Basic Strategy built in.
- Use an online service that builds and maintains a portfolio that you can customize to some extent. Most services are designed to use Basic Strategy.
- Hire an advisor to customize, implement, and enforce an investment strategy based on your specific needs. For my clients, I start with Basic Strategy and only layer on enhancements that are supported by convincing evidence.
You really owe it to your future self to do better than the average investor. The cost of doing what most investors do are high, especially for younger investors who have many decades to invest.