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The Single Largest Hurdle to Portfolio Returns

I see articles daily focusing on how to eke out that last extra return. You can read about efficient market frontiers and investing in leveraged stocks. You’ll hear about indexing as I have done in this blog and active investments. But you know what? For the average American none of it really matters to your end return.

The reality is despite all the information about how to manage a portfolio efficiently, the average person does not meet the market average returns. They don’t even meet active investor returns which tend to lag the index. No, according to a recent study conducted by Dalbar, a financial research company, the average investor portfolio return lags the average of all US stock funds by approximately 7.4%. They returned an average of 3.7% annually over the course of the past 30 years, which is just barely an eke better then inflation. Why so bad?

Low Portfolio Return is the Investor’s Fault

There are 2 reasons, and both ultimately lie with the investor not the investment. The first is a cost hitting at the worst possible time driving a sale of an asset. You can offset this by having an emergency fund. That fund will ensure you’re not selling out of the stock market at its bottom. This is solvable with a little bit of research and time.

The second and larger driver is individual behavioral biases. We see the market go down and the pundits scream the market is collapsing, so we sell. We see the market going ever up and people finally get back in. I saw this in my own family when relatives of mine sold all their stocks and bought bonds in 2009. No amount of education is going to change how you react when the stock market is down 40%. It may lessen your likelihood to overreact, but nature’s tendency is for humans to have a larger aversion to a loss than the benefit of an equivalent gain. This tendency is often called Loss Aversion. A loss of 2% has a larger psychological impact on you as a human then a gain of 2%. A loss of 40% magnifies that by 20. Not many people are suited to withstand that bias.

This is why when someone who is on the younger side of the age equation suggests they are 100 % in the stock market, I shake my head. Odds are very good they will lag the market over the next 20 years. There may be 1 or 2 exceptions to the rule, but in general you can’t know if that person is you until you’ve experienced a loss. Your Risk Tolerance, or essentially the amount of loss you can handle, is not something you can know until you experience it. In fact, it can differ throughout your life. As a 40 year old retiree with no other income source, your risk tolerance for your portfolio would be lower then a 22 year old fully employed individual.

Plan Accordingly

Knowing all this, you shouldn’t shut out the stock market, as ultimately you will never retire.

What you should do is:

  • Take an investment stance where some of your money is not tied to the performance of the stock market. The more risk adverse, the more this pot should be, call it comfort money. Typically, pundits suggest your age in bonds for this portion of your portfolio.
  • If you are predisposed to sell you should lock up your investing accounts in such a way that you do not touch them except at predefined yearly balance points. If you have to give your account password to someone you trust or lock yourself out of the account. Then do not watch Market news. Ultimately, your account will do better for it.
  • If you really feel the need to market time set a small portion of your investments in a separate segregated account as play money. Whatever you do don’t mix this account with the rest of your money. Then feel free to shoot the moon, though remember it is likely you will end up without this money in the end.

Remember, ultimately you are your own worst enemy when it comes to retirement. How do you keep your Loss Aversion bias in check?

6 Comments

  1. Arrgo
    Arrgo October 24, 2016

    I very much agree with this. With market timing I’ve done, I’ve probably only been about 30% successfull. Its not so much that Ive lost money, but more about buying higher or selling lower than I could have. Factor in the worrying/ stress/ and time spent, its not really worth it over the long term. After over 20 years of investing, my accounts now are pretty huge considering I have never made big money at my job. But Ill tell you what worked for me: I just set up my IRA and 401k for automatic contributions. I started maxing out my 401k starting during the recession. Even though Ive always enjoyed reading about finance, I never really put much effort into it other than the going to work part of coarse. I might have looked at my accounts every month or 2. It was like a bill I had to pay and retirement was a long way off so i didnt worry about it much.

    • fulltimefinance@fulltimefinance.com
      [email protected] October 24, 2016

      Argo, definitely a great approach. It’s also so easy to fall into the trap of market timing. The reach for the illusion of control is like a sirens call, but it’s a bad idea to tinker. Thanks for adding some great ideas.

  2. Andrew Li
    Andrew Li October 27, 2016

    FullTimeFinance,

    Great discussion. I am always interest in behavioral finance! I definitely agree that biggest threat to your long-term returns is yourself.

    As a funny story, under the stewardship of legendary investor Peter Lynch, Fidelity’s Magellan Fund generated 29% annual returns between 1977 and 1990.

    What’s interesting is that Fidelity went back and looked at all the weighted average buy/sell trades from client accounts and learned that over the 13 year period the average investor lost money!

    • fulltimefinance@fulltimefinance.com
      [email protected] October 27, 2016

      It truly is scary when you really dig into how easy and common it is to tank your investing returns.

  3. Investor Tuition
    Investor Tuition October 30, 2016

    Your comments are so true. As an ex adviser of 25 years, time and time again I saw clients who “could do it better”. but never really could.

    I actually had a client who genuinely believed that the earth was flat. Yes, you read this correct. He believed that the earth we live on, was as flat as a pancake, and there was heaps of evidence to see on YouTube! Absolutely unbelievable I know, in this day and age.

    But, here’s the clincher, he actually wanted to start his own self managed super fund because he believed he could invest better! How about that, someone who genuinely believed the earth was flat, also believed they possessed far superior investing skills than a diversified range of professional fund managers. Go figure!!

    Good post, regards Adrian

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