The average
stock investor’s earnings lag significantly behind the market as a whole.
Precise estimates vary as to how much, but the main reasons for many individuals' under-performance are quite simple:
chasing returns, and excessive fees.
‘Fear and Greed’: Lessons from
Behavioral Finance Theory
A recent
study by the Boston-based financial-research firm Dalbar found that the average
investor in all U.S. stock funds earned 3.7% annually over the past 30 years,
while the S&P 500 stock index had an annual return of 11.1%. In other
words, the market outperformed stock-fund investors by about 7.4% annually over
three decades.
What
accounts for this gap? For one, the return on funds – and market indices like
the S&P 500 – are measured as if an investor put all of their money in at
the beginning and then left it untouched for the entire period. But most investors
will put money in and take money out along the way.
Also, most
funds lag the S&P, probably accounting for about one percentage point of
the gap in the Dalbar study. And, as will be seen below, fees and expenses
account for at least one more percentage point in the aggregate figure. Then,
further muddling the picture, many believe the Dalbar figure overstates the gap
between investors and the market (more on that below as well.)
But to the
extent that the average investor really does lag behind the market in investment
performance, the biggest culprit is what behavioral finance theory refers to as
chasing returns. Many investors jump into the market after a hot streak and
then flee when it goes the other way, and because they buy high and sell low,
oftentimes investors in the typical fund have a lower average return than the
fund itself.
In measuring
an investment’s returns over time, only those who held the investment for the
entire time will match that performance. In actuality though, some will even do
better if they manage to buy low and sell high, but most will do worse. For
example, one study found that stock investors lagged behind the stock market
itself by 1.3 percentage points between 1926 and 2002. Others have show that
even pensions and other “sophisticated” or institutional investors earn about
three percent less than the hedge funds they buy. Still others show that mutual
funds tend to outperform their investors by between one and two percentage
points annually.
That is
because on the whole, when the market heats up, money flows in, and when it
cools down, it exits. Critics of the Dalbar figure, which indeed appears to
show a much larger gap than these others, believe that it exaggerates the truth
because, rather than using a standard formula that adjusts the results based on
when performance was earned and when money was introduced or withdrawn from the
fund, its calculation takes returns over the full period and divides them by
total assets at the end, including money that wasn’t there from the start.
But even if
it is an exaggeration, it describes a real phenomenon. Money rushing in at the
top of the market means a portfolio manager has no choice but to buy overpriced
stocks, while, conversely, investors fleeing the market at the bottom means he
has sell the stocks right when they become cheap. (Then to rub salt in the
wound, after the manager sells stocks to cash out the investors who flee, any attendant
capital-gains taxes will be shouldered solely by the investors who stay.)
So what can
you do? For one, you can look at Morningstar.com, where the “performance” tab
at each fund’s page enables you to compare fund returns against investor
returns. Then if the gap between the two numbers is greater than one or two
percentage points, you can look for another fund that is less welcoming of hot
money.
And,
perhaps, you can do better than your fund if you are disciplined about adding money
when markets fall and then holding firm (or trimming a little) when markets are
on the rise – or, in other words, buying when you feel like selling, and vice
versa.
But if there
is one other main lesson to take away from the Dalbar study, it may be this:
part of the (much larger) gap that it shows between investors and the market
likely stems from its method of comparing the returns of fund investors to an index over time, rather than to the
funds themselves. While, from one perspective, that might mean that it
overstates the impact of “chasing returns” on investor performance, from
another it appears to provide a compelling argument for the average investor to
simply buy index-tracking funds and then hold onto them to the extent that such
is feasible.
That way, if
they cannot beat the market (i.e. consistently, over time), at least they
probably won’t do much worse. Unless, that is, they become a victim of
excessive fees.
To Get the Most From Your Money, Keep
an Eye on the Fees
We’ve
already seen how investor behavior can hurt performance, and that actively
seeking to beat the market is, for the average investor, a quixotic pursuit
almost certain to fail (especially over extended periods of time, as life’s
needs and wants intrude on optimal investment strategy) – and that most
investors will likely do much better by instead simply trying to track the
market’s performance. But that is only one side of the coin for maximizing
investments. The other is avoiding and reducing fees in any and every way
possible, whether in hiring an investment adviser or putting money into mutual
funds.
Most fees
can be reduced, negotiated or eliminated by shopping around and haggling, and
the payoff for such efforts can be substantial.
For example:
An investor who had $200,000 in a mutual fund would pay $2,500 based on the
average annual fee, while the same sum in a broad-stock-market index fund could
cost as little as $80. Over 30 years, with fees and returns compounded
annually, that gap alone would cost the higher-fee investor about $570,000, if
both investments return 8% a year before fees.
Moreover,
when interest rates are low, and many investments generate unexciting returns, the
impact from lowering costs can be particularly notable.
Paying fewer
fees means more money saved and more money working for you in your account. Fortunately,
there are a number of ways for a cost-conscious investor to do so, both in
seeking financial advice and making investments.
Financial Advice
Advisers at
large Wall Street banks typically charge investors around 1% of the value of
assets under management per year, and they provide a variety of services, such
as helping clients to plan for retirement, choose an appropriate balance of
investments and pick individual stocks and funds.
Investors
can cut that fee significantly if they can make do with less hand-holding.
Many
independent financial advisers will prepare a bare-bones financial plan,
including a household budget analysis, a projection of retirement needs and a
model portfolio of stocks and bonds, for $500 to $1,500, according to Eleanor
Blayney, a consumer advocate for the Certified Financial Planner Board of
Standards in Washington.
While those
services probably wouldn’t include actually managing a client's money, for an
investor with a portfolio of $200,000, that could mean saving $500 or more. (Moreover,
many advisers at Wall Street firms will only work with clients who have
$500,000 to $1 million or more to invest.)
Also, any
investor who wants to hire an adviser should meet with at least three
candidates, and should not hesitate to ask an adviser to lower fees if a
competitor charges less for the same service.
Then there
are other low-fee options, including a fee-only planner who charges by the hour
or project, and who is often the least-expensive choice. Such arrangements can
work well for an investor who only needs a quick consultation.
Another
option: Go virtual.
Many new
firms offer financial advice over the Internet, and while they might not
capture the nuances that a traditional adviser would spot in a face-to-face
meeting, they generally charge less.
In some
instances, investors can get matched up with financial planners who may, for
example, put together five-year plans for retirement preparation, debt
management and savings. Then investors who want recommendations for how much of
a portfolio to allocate to stocks or bonds can pay an additional fee, and then
implement that strategy.
Other
companies automate that process. Prospective clients answer short online
surveys about savings goals and risk appetite, and the companies generate
recommended portfolios of low-cost ETFs based on computer algorithms. If you
like what you see, you can set up an account and they will make the investments.
Discount Brokerage
Stock-trading
fees have fallen sharply over the last few decades. In 1991, Charles Schwab
charged $74 a trade, according to research by Aite Group, a Boston data firm.
Starting in
2010, the drop became more acute as discount brokerages tried to lure back
investors who had cut down trading activity after getting burned by losses in
the financial crisis.
Active investors
can still benefit, as prices haven't bounced back up. Currently the average fee
per trade is $8.82, according to San Francisco-based NerdWallet.com, which
tracks financial firm fees.
Investors
who trade infrequently, or who will do most of their trading right after they
open an account, should check for promotions that might let them avoid fees
altogether.
Mutual Funds and ETFs
Mutual-fund
fees have been coming down in recent years. But there is still a big difference
between what a typical investor and a cost-conscious investor might pay.
Fees vary
greatly based on a number of factors, including the fund company, the type of
asset and the management style.
The average
mutual fund had an expense ratio of 1.25% in 2013—or $125 annually per $10,000
invested—down from a peak of 1.47% in 2003, according to Chicago-based
investment-researcher Morningstar. But for many types of funds, investors can
do much better.
For example,
consider the return on a $100,000 investment in the Vanguard 500 Index Fund,
which is designed to track the S&P 500. It charges 0.05%. If the Vanguard
fund has an average annual return of 8%, before fees and taxes, at the end of
30 years the investor would have more than $990,000, if fees and returns were
compounded annually.
On the other
hand, the investor in the average mutual fund would only have about $710,000,
assuming the same pre-fee return.
For another
example, one of the target-date retirement funds offered by Vanguard has an
expense ratio of 0.18%, while other comparable options charge between 0.7% and
1.1% annually.
In general,
index funds and ETFs tend to have the lowest fees, and when deciding between
funds that track the same index, "virtually every time, you should go with
the lower cost fund," says Russel Kinnel, who researches funds for
Morningstar.
To cut
expenses even more, investors might consider ETFs that track slightly obscure
indexes that are similar to pricier peers.
For example,
an investor might traditionally use an S&P 500 ETF to invest in
large-company stocks. However, according to ETF.com, the cheapest large-cap
stock ETF is Schwab U.S. Large-Cap, which has an expense ratio of 0.04% and
tracks the Dow Jones U.S. Large-Cap Total Stock Market Index. (See the
lowest-cost ETFs for various fund categories in the table on this page.)
For ETFs,
investors also will want to make sure that the fund's "bid-ask
spread" isn't more than three cents for a stock ETF and five cents for a
bond ETF. The spread is the difference between the highest price that a buyer
will pay and the lowest price at which a seller will sell, and a large spread
can quickly offset the cost advantage of a low expense ratio.
Finally,
while actively managed mutual funds tend to carry higher costs than index
funds, investors in active funds should also make an effort to limit fees. Generally,
investors shouldn't pay an annual fee of more than 1.25% for U.S. large-company
stock funds, more than 1.75% for U.S. small-company stock funds or more than
1.5% for U.S. bond funds. To see a mutual fund's expense ratio and how it
compares to the average, look up the fund at Morningstar.com and click on the
"Expense" tab.
The higher
the manager's fee, the harder it will be to beat an index fund, and, once
again, most managers fail to do so
consistently.
This article includes information drawn from research
in the Wall Street Journal.