Since 1929 U.S. stocks have provided a real return of 5.9% per year. So if you sell a business and have a long time horizon, it makes sense to invest in stocks. The cheapest and easiest way is to buy an index mutual fund or ETF. But that is not the smartest thing to do. It is better to find an experienced, trustworthy investment advisor to help manage your money.
Why? Not because they will be such great stock pickers that they beat the stock market by a substantial margin. I know a couple of talented professionals who can do that, but it is very difficult because the market is so efficient. AIG’s Hank Greenberg once remarked, “All I want in life is an unfair advantage.” Me too, but it is hard to find in the stock market, what with every trader, analyst, and broker having available on his desktop, via Bloomberg or FactSet, the income statement, balance sheet, cash flow statement, trading history, SEC filings, ownership data, conference call transcripts, relative valuation metrics, technical charts, event timelines etc. on thousands of companies.
And keep in mind that advisors who do have a lengthy record of beating the market may have done so by taking too much risk. An example is Legg Mason’s Bill Miller, a talented fellow who beat the S&P 500 for ten years in a row. He made concentrated, contrarian bets on unloved sectors – which after 2006 included housing stocks and financial stocks. Woops. The fund dropped 55% in 2008; assets declined about 87% between 2007 and 2011 (partly due to withdrawals).
So why use an advisor if they are not too likely to beat the market significantly? Because individuals, left to their own devices, tend to vastly underperform the stock market. Consider:
- Dalbar, a market research firm, “utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior…. Based on this behavior, it calculates an average investor return.” Over the two decades ending 2008, the average investor return was +1.87% versus +8.35% for the S&P 500.
- Former New York Times reporter Hedrick Smith’s book Who Stole the American Dream? (his answer: conservatives, even though the dream disappeared in the 1970s when liberal policies reigned) has an interesting chapter indicting 401(k) plans because typical investors vastly underperform the market. The State of Nebraska offered a 401(k) type pension plan to employees, but the legislature wondered whether it worked properly. So they ran an experiment. Employees were split into two groups; a group of workers who ran their own money and another pool of funds run by professionals. The professionals soundly beat the amateurs, 10.5% per year vs. 6.5%.
- The reason for individuals’ poor performance is that they get in and out of stocks at the wrong time and chase performance by buying “hot” funds after they have become expensive. A National Bureau of Economic Research study of mutual fund s found that “Fund flows are dumb money. By reallocating across different mutual funds, retail investors reduce their wealth in the long run.”
As an aside, individuals’ terrible record as market timers is currently a very bullish signal. They have been net sellers of domestic stock mutual funds in 30 of the last 36 months, including each of the past 18 months. Count on them to get back into stocks after they are up 50-100%. In our next installment on this topic, we’ll explain why it is so difficult for individual investors to stay fully invested.
References: Ben Inker, “Reports of the Death of Equities Have Been Greatly Exaggerated: Explaining Equity Returns” GMO White Paper August 2012 (highly recommended); Hedrick Smith, Who Stole the American Dream? (2012); Andrea Frazzini, Owen A. Lamont, “Dumb Money: Mutual Fund Flows and the Cross-Section of Stock Returns” NBER Working Paper Series, July 2005.
Copyright 2012 Thomas Doerflinger. All Rights Reserved.
