HOW TO BEAT THE AVERAGE INVESTOR
By Patrick Malcolm
Investing is more than mathematical analysis of risk and return. It’s a struggle to tune out irrelevant information, to have the strength to stick to an investment strategy and to resist the urge to follow the herd. Investors are often told to avoid the emotional roller coaster and magically remove emotions and temptation.
The sad reality is that the average individual investor has little chance of beating the market, with all the evidence supporting the fact that regular investors as a whole underperform the market.
Over the last decade, a different approach has started to emerge within behavioural science – one that accepts the fact that investors are merely human. They have a limited attention span and an unlimited capacity to mess things up.
Behavioural scientists study how the fundamental wiring of human beings drives behaviour, and how that can undermine the potential to build wealth over time. Instead of denying the limitations, researchers are learning how investors can work with (or around) human nature.
Investors face complex, multifaceted questions regularly. So, their minds take shortcuts – which make the task of investing feasible but introduce mistakes that can end up costing them. Some examples of these shortcuts include:
- Copying what other people are doing
- Avoiding a decision altogether, and taking no action until they are forced to
- Simplifying complex choices. If there are ten options, investors might put 10% of their investment in each one – even if one is already well diversified.
Perhaps the most troubling aspect of using these shortcuts – also known as behavioural biases – is that investors often don’t realise they’re happening. Moreover, even when they realise, they can’t just turn them off.
Why? They are part of the automatic response of the brain, outside of conscious awareness. The answers they come up with “feel” right. Investors can’t avoid using the shortcuts because human minds can’t handle the underlying math that some investment decisions require.
Logically knowing what to do isn’t enough. Humans are good at recognising the right thing to do but are inconsistent about actually doing it. They can’t overcome these problems by force of will; instead, they have to remove their frailties from the equation or put tremendous time and energy into avoiding these mistakes.
Rather than dedicating their entire life to investing (and psychology), many investors recognise the limitations they face and turn to professional advisers for help. At GFM Wealth Advisory, our advisers attempt to simplify investment analysis and avoid common mistakes, to help investors overcome the challenges talked about.
At GFM Wealth Advisory, we aim to build portfolios with a high level of diversification. Exposure to a diverse range of asset classes, size of investments by market capitalisation, styles of investment, geographies, fund managers and investment strategies significantly reduces the risk of poor performance within an investment portfolio. However, market conditions can change, as can the characteristics of investments. While we believe in a long-term investment philosophy, it is not a ‘set and forget’ approach.
Staying the Course:
Those who attempt to time the market run the risk of missing periods of exceptional returns, leading to significant adverse effects on the ending value of a portfolio.
It is natural to have an emotional reaction to changes in fortune. However, acting on that natural emotion can end up making things worse. Investors may leave the market and miss out on the subsequent recoveries.
An investor who exited the market at the bottom of a downturn, waited for a year, and then reinvested would have missed out on the recovery.
The Cost of Market Timing:
Those who attempt to time the market run the risk of missing periods of exceptional returns, leading to significant adverse effects on the value of a portfolio.
The chart below shows the daily gains and losses in the Australian stock market since 1996. Within that “noise” are the 100 top returning days to be invested.
The chart below shows the impact of being invested throughout the period compared with missing a varying number of the best investing days.
Those who stayed in the market for all trading days achieved a compound annual return of 11% per annum. However, that same investment would have returned only 8% per annum had only the 20 best days of returns been missed. Further, missing the 200 best days would have produced a loss of 3% per annum.
The appeal of market timing is obvious – improving portfolio returns by avoiding periods of poor performance. However, timing the market consistently is challenging. Moreover, unsuccessful market timing, the more likely result, can lead to a significant opportunity loss.
The importance of staying invested:
One of the significant factors that make investments risky is human behaviour. In a study, investors who actively traded stocks in the market made mistakes again and again – and had returns that were one third lower than that of average returns.
While there are many ways in which investors can run into trouble, three types of problems are prevalent:
- Chasing returns. If you’ve ever talked with friends about the stock market at a BBQ, you’ve probably felt the urge to invest in a new hot stock or sector. The problem with this is: so does everyone else so you may not investing at an opportune time.
- Picking unsuitable investments. Investors are inundated with information. It can be overwhelming, so they often go with what feels right. Unfortunately, for complex issues like asset allocation, diversification, and portfolio selection, the more intricate details matter, because they help drive long–term growth and determine whether investors can reach their goals.
- Exiting the market during downturns. When the markets get jumpy, people ask themselves, “Is the market going to fall more, and should I get out of the market?”
The chart below illustrates the value of a $100,000 investment in the stock market during the period October 2007–December 2018, which included both the global financial crisis and the recovery that followed:
The value of the initial investment dropped to $49,422 by 6 March 2009 (the trough date), following a severe market decline. However, if an investor had remained invested in the stock market throughout the period, the ending value of the investment would have been $136,236 (light blue line).
If the same investor exited the market at the bottom of the trough to invest in cash for a year, before reinvesting in the market, the ending value of the investment would have been $89,351 (grey line).
An all-cash investment at the bottom of the market would have yielded only $66,035 (dark blue line).
The continuous stock market investment recovered its initial value and provided a higher ending value than either of the other two strategies.
Tune Out the Noise!
There’s a reason that investors tend to only hear about “looming” market doom or “imminent” market growth. While many news outlets have the incentive to draw attention with wildly bullish or bearish predictions, these sensationalised views are a distraction to a sound investment approach. When tempted to make a radical change based on these headlines, it is important to recall some investing fundamentals.
Drown out the noise:
Market movements are notoriously difficult to predict. The media outlets that scream the loudest are not always the most accurate. The fallout from attempting to time the market in response to one of these predictions can be dangerous.
Look, but don’t stare:
While it’s important to know the performance of portfolios, short–term market fluctuations can be quite volatile. While the probability of realising a loss on any given day is high, the likelihood of achieving a loss has historically decreased over longer holding periods. Periodic review of investment portfolios is necessary.
Stay focused on the long term:
Stick to a plan based on your specific goals and your risk tolerance. While it may not always grab headlines, a sensible, tailored approach is the best solution to meeting your long–term goals. What may be right for your friend at the barbeque may not be right for you.
Possessing a considerable amount of knowledge about investments is only a small part of the planning process. Many investors are under the false notion that the most significant determinant of portfolio performance is the specific investment choices made. However, the most critical decision is how much to allocate to different asset classes.
Asset allocation is all about finding the mix of investments that is right for your situation. Your specific goals, time horizon, and risk tolerance are some of the critical factors that should be considered when selecting assets within the portfolio.
While we believe in a long term investment philosophy, it is not a ‘set and forget’ approach. Market conditions can change, as can the characteristics of investments.
It comes as no surprise that over time, the outlook of one asset class compared to another fluctuates due to economic events, asset valuations and investor sentiment. There are often extended periods where valuation factors will significantly differ from long–term values.
“Don’t put all your eggs in one basket” is a common expression that most people have heard in their lifetime. It means don’t risk losing everything by putting all your hard work or money into any one place.
To practice this in the context of investing means diversification – the strategy of holding more than one type of investment in a portfolio to reduce risk.
A diversification strategy reduces risk because different types of investments generally do not react identically in changing economic or market conditions. Diversification does not eliminate the risk of experiencing volatility or investment losses. However, by investing in a mix of investments, investors may be able to insulate their portfolios from significant downswings.
Over the long term, it is common for a more risky investment (such as shares) to outperform a less risky diversified portfolio. However, one of the main advantages of diversification is reducing risk, not necessarily increasing return.
Avoiding significant losses remains a crucial element in building wealth. This focus is warranted as heavy losses require very high rates of return to restore the original capital. For example, a 100 per cent gain is needed to recoup a 50 per cent loss.
No single asset class either outperforms or underperforms consistently, therefore diversifying across multiple asset classes, reduces overall risk. It reduces the likelihood of any single asset class adversely affecting performance and smooths the return profile of your portfolio. Losses made in one asset class can be offset by gains in others.
A diversified portfolio is neither the best nor, more importantly, the worst–performing investment in any given year. The risk of a significant loss to capital is significantly reduced, and the overall return is less volatile.
Active Management Does Add Value:
Market pricing is frequently not efficient because of behavioural biases and the short–term focus of investors. Managers with the right skills, resources and processes can create excess returns with active strategies.
At GFM Wealth Advisory, we can choose investments and managers that we expect can help achieve the best outcome for our clients. We have no commercial or other relationships with any fund manager other than to seek to identify those managers that can genuinely and consistently add value.
The selection of an investment is never an easy task and involves comprehensive due diligence on our part. GFM Wealth Advisory’s investment process comprises a filtering process where investments from a particular universe are gradually removed until a handful of options are left to be chosen from. We use several mathematical tools that are available to further assist in the decision making process, such as analysis of rolling excess returns.
This involves looking at the pattern of returns achieved above the benchmark over a period.
A period needs to be chosen over which to analyse the rolling returns. This should be a long enough period to capture differing economic conditions and market cycles. However, we often use using additional periods to aid the analysis further.
It isn’t all about capital growth…
On its own, the price growth of Australian shares has been underwhelming. Over the ten years to the end of May 2019, the S&P/ASX 200 Price Index has produced a return of 5.30% per annum, as highlighted in the chart below:
However, share investing is not all about capital growth. When dividend income is added, the S&P/ASX 200 has returned 10.05% p.a. over the past ten years to 31 May 2019, as can be seen in the chart below:
This is better than 5.30% for capital growth. Over the same ten year period, the official overnight cash rate has averaged 2.73% p.a., while the one-year term deposit interest rate averaged the 3.64% p.a.
However, the term deposit income didn’t include franking credits, which the dividend income stream did.
Franking is invisible, with investment returns conventionally reported pre-tax, excluding franking.
Franking credits are tax credits that a company distributes to its shareholders with its dividends, representing tax the company has already paid.
When your shares return a profit, the company pays corporate tax on the dividends, which is currently 30%. You receive the dividend with a franking credit attached to it for the amount of tax the company has already paid, which you may be able to get back as a rebate.
In 2000, franking credits became fully refundable to low tax Australian investors, helping to supplement the returns for superannuation funds and tax exempt investors. For tax exempt investors such as pension phase superannuation funds, franking credits increase returns significantly.
Using the S&P/ASX 200 Franking Credit Adjusted Annual Total Return Index (Tax–Exempt), franking credits have increased the total return for tax exempt investors like pension phase superannuation investors and low income investors by 1.67% p.a., giving a tax exempt total return of 11.72% p.a. over the ten years to 31 May 2019.
However, Growth Still Matters:
Even income investors need growth. Without growth in earnings, there can be little growth in dividends, and without growth in dividends, income will be eroded by inflation.
Even for income-focused investors, we believe in building portfolios that generate capital growth over extended periods.