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How investors beat themselves

“Surprise! The returns reported by mutual funds are not actually earned by mutual fund investors.” This is how John Bogle, founder of Vanguard Mutual Funds begins the chapter titled The Grand Illusion in his 2007 book, The Little Book of Common Sense Investing. The “grand illusion” Mr. Bogle is referring to is the fact that mutual fund investors consistently fail to earn the returns of the financial markets. According to Bogle, during the 25-year period from 1980 to 2005, the return on the stock market (as measured by the Standard & Poor’s 500 index) averaged 12.5% per year, yet the average fund investor earned a mere 7.3%, or less than 60% of what the average fund returned.

Although recent studies employing more sophisticated methodologies have arrived at less startling results, their conclusions still present a grim assessment of the average investor’s track record. An example is the best way to demonstrate the implications of poor investor performance in stark dollars and cents terms. A difference of just 3% (7% vs. 4%) in annual returns on a $100,000 portfolio invested over a 30-year period results in dramatically different ending wealth balances. The 7% return would have generated $761,000 at the end of the 30-year period as compared to just $324,000 for the 3% return. This hypothetical investor who assumed 100% of the risk would have forfeited almost 60% of the return that he could have otherwise earned.

What’s the reason for such a stunning performance gap? Although some of the lag can be attributed to the high fees that investors pay to own most mutual funds, the main cause is the investors’ own behavior, specifically counterproductive market timing and fund selection. Stated simply, investors chase performance, pouring money into those asset classes (e.g. stocks, bonds, etc.) and mutual funds that have recently experienced the biggest gains, only to lose conviction and sell after experiencing an inevitable and painful decline.

Buying high and selling low is obviously a flawed investment strategy. Yet many investors fail to practice what common sense dictates and make this mistake repeatedly, causing permanent damage to their portfolios. At some level, this disconnect between rational thinking and emotional behavior is understandable because investment decisions are different from other types of decisions we make in life. With non-investment decisions, past experience is often a reasonable predictor of future performance. With investing, however, often the opposite is true. Not only is past performance an unreliable predicator of the future, but also recent past performance is in fact often a contrary indicator of what is to come. In other words, the types of investments that have recently declined in value the most may prove to be the better performing investments in the future. Unfortunately, this contrarian approach is easy to understand intellectually but emotionally difficult to implement. This is especially true during times of financial crisis when otherwise rational people are overcome with the fear that the future will bring even more bad news.

As powerful as emotions are and as difficult as they may be to overcome, successful investors understand they must do so. It begins with a realistic understanding of how the financial markets work. Sudden surges and frightening drops in the market are to be expected. The successful investor will avoid making impulsive decisions and instead, employ a long-term investment plan rather than succumb to the emotions of greed when the markets surge and panic when they plummet. It is clear that investors consistently fail to earn the returns that they should. It is time to change that.

The Power of Compounding

Compound growth, also known as exponential growth, is one of the most powerful yet least understood forces in personal finance. Even a basic understanding of how it works and its effects on building personal wealth could motivate investors of all ages to make smarter saving and investing decisions especially in the area of retirement planning.

It’s no surprise that research on people’s ability to estimate the effects of compounding on their savings has consistently found that even sophisticated consumers dramatically underestimate its wealth building potential. Conceptualizing and calculating the effect of exponential growth on savings when regular contributions are made to an account is neither intuitive nor simple. Nevertheless, this calculation is fundamental to making the kinds of important financial decisions that Americans face every day.

The best way to demonstrate how compounding works is by example. For the sake of simplicity we will ignore the effect of inflation. Consider a 25 year old investor just getting started in her career. She begins saving and investing a fixed amount of $10,000 at the end of each year toward her retirement in a portfolio that earns 5% annually after-tax. She reinvests those earnings at the end of each year in the portfolio and allows them to grow untouched. Upon reaching age 65 (after 40 years of growth) the account would be worth almost $1.3 million.

The principal variables that influence the compound growth of an investment are the amount the investor saves, the rate of return earned on the assets and the period of time the investments are allowed to grow untouched. Even relatively small variations in these factors can have outsized effects on the ability to build wealth. Let’s see how changes in our underlying assumptions influence the results.

Contribution amounts. Spending less than you earn and saving and investing the rest is the basis for building wealth. If our investor decided to increase her contributions by 6% each year (e.g. $10,000 in year 1, $10,600 in year 2, $11,236 in year 3, etc.), from pay raises and promotions, she can more than double her retirement account balance at age 65 to over $3.4 million. For most people with even modest career trajectories, increasing savings by 6% annually is a reasonable goal. Establishing and adhering to a disciplined and automatic saving and investing program is the key to accomplishing this.

Investment returns. As you might expect, the rate of return earned on a portfolio affects the growth of the account. If the investor earns 4% instead of 5%, the ending balance at age 65 would be reduced by about 15% from $3.4 million to just under $2.9 million. Remember, other than building and maintaining a well-conceived investment portfolio, investors have little control over the returns they earn from the financial markets. Good advice for all investors is not to expect to make up for saving too little today by hoping to earn high investment returns in the future.

Time horizon. For the investor time can be a friend or an enemy. Which of the two depends upon how much has already been saved and how soon the nest egg will need to be tapped. In simple terms, the longer you delay saving the harder it will be to make up for lost time. Wait to start saving from age 25 to age 35 and instead of accumulating $3.4 million you will have only $1.5 million by age 65. Procrastinate until age 45 and the account balance grows to less than $600,000. Viewed another way, in order to build a certain size nest egg for retirement, if you wait until 35 to start saving, you’ll need to save twice as much each year than if you started at 25. Wait until age 45 and you’ll need to save six times as much (a nearly impossible task for most people).

Smart spending, saving, investing and borrowing decisions cannot be made without an understanding of compounding. Those investors who take the time to understand its effect on building wealth will make better financial choices. They will recognize the benefits of saving early and often, choosing the right investments and establishing realistic retirement goals.

The Problem with Predictions

“The members of the Barron’s Roundtable see a year of modest gains for U.S. stocks, trouble for bonds, and good news for gold.” This was author Lauren Rubin’s lead in to her January 2013 Barron’s article summarizing the 2013 investment predictions of the financial “luminaries” that comprise Barron’s Investment Roundtable. How did they do? Not well. U.S. stocks notched remarkable (not modest) gains surging over 30%. Bonds delivered mediocre but certainly not “troubling” performance of about 3%. Gold investors didn’t fare so well. Rather than the anticipated good news, investors in gold funds watched their shares plunge 25% in the last 12 months. Undeterred, Barron’s will be reconvening these “masters” of the investment universe for another round of prognostications in early 2014.

Stock market predictions are as old as the stock market itself, and this cycle repeats itself year after year with similar results: some forecasts turn out to be remarkably prescient while others miss the mark completely. Unfortunately for those who invest based on these predictions, the forecasters who happen to get it right one year are often not so lucky the next. The fall from guru status seems to be certain and swift. In any given year the factor distinguishing those who are right from those who are wrong is pure chance.

A mountain of evidence collected from research conducted over the last 100 years by some of the most renowned mathematicians and economists indicates that investment experts are no more able to forecast short-term market direction than the rest of us. This suggests that predicting stock market performance consistently is not merely difficult – it may actually be impossible. This fact, however, has done little to discourage the financial industry and news media from trotting out their “expert” predictions for the overall market and specific stocks for the upcoming year. There are two simple reasons for this.

First, the financial payoff for those who are lucky enough to guess correctly is enormous. Investment gurus provide the marketing hype for their organizations. Guess right and the advertising and promotional machine cranks up. Guest spots on CNBC, articles in the financial press, and promotional material touting superior investment returns has the powerful affect of attracting a flood of new investors and millions of dollars in assets to the organization. Guess wrong and they defend their positions with a cleverly worded rationale and complicated charts. Thus, there is no downside to making a prediction so long as it is remotely plausible.

Second, despite their questionable value, these predictions remain popular with a less experienced investing audience. For most Americans, especially those nearing retirement or already retired, their wealth is materially affected by the rise and fall of stock prices. The stock market represents a complex system that is affected by multiple factors including expectations of future economic and geopolitical conditions as well as random events. Studies in behavioral finance suggest that when making decisions in the face of such uncertainty people tend to rely on those who are seemingly able to offer predictability in otherwise unpredictable situations. There are plenty of investment professionals who are happy to offer that predictability. Smart investors will recognize their limitations.