All About the Benjamins

There is only one reason that any of us risk money in the financial markets, to generate a return above and beyond what we can earn from an interest bearing checking account, savings account or the equivalent.

Despite this singular focus, the reality is that most investors underperform every asset class on earth, including the 3-month US Treasury Bill (cash). So, while the media spends most of their time discussing whether active money managers outperform each other or arbitrary benchmarks, the average investor barely earns enough return to keep up with inflation over long periods of time.

 

Average Investor’s Returns

Richard Bernstein Advisors (RBA) measured the performance of 44 asset classes over the last 20 years and found that the “average investor” underperformed every asset class but 3, including cash (3-month US Treasury bill), earning just below 3% on an annualized basis.

Looking at this chart, you can see that this underpeformance isn’t from a lack of opportunity. Of the 44 asset classes studied, 29 (66%) of those asset classes earned over 6% per year, doubling the average investors return.

Morningstar actually tracks a statistic, which shows the average investor performance for a given fund. For instance, the Allianz Global Dynamic Allocation Fund, has a 5-year annualized return of 7.67%. However, the average investor return in that same exact fund over that same time-period is a paltry 85 basis points each year.  The average investor in that fund underperformed the actual fund’s returns by 6.8% per year!

Keep in mind, that this underperformance occurred during one of the better bull markets we’ve seen over a 5 year period of time. I will be the first to admit that this is an extreme example. Morningstar estimates that, on average, investors are underperforming their fund’s performance by 2.5% per year.

We live in a world of compounding; 250 basis points a year is a huge difference. On a $1MM account, that 2.5% difference equals $112,000 over 5 years and $303,000 over 10 years in lost earnings.

So why do investors leave so much money on the table? There are two main culprits: performance-chasing and loss aversion bias.

Investors are notorious for moving money into the fund with the best recent performance only to watch the returns dwindle.

They then pull the money from that fund in the midst of a decline and re-allocate to today’s hottest fund, and so on and so on. I’ve talked repeatedly in TWR about the dangers of chasing a market that has either risen or declined very rapidly.

We all have the 'FOMO' gene - fear of missing out. Mutual fund or other money managers are no different.

Caution and proper due diligence are required when evaluating managers who have phenomenal recent performance. Basically, it comes down to a question of skill or luck, which is a topic for another day. The other handicap that hurts investors is a natural aversion to loss. Loss aversion is a bias in decision making driven by our emotions.

There are many other biases that hurt investor performance but loss aversion is at the top of the list. It causes to buy and sell investments, whether its active managers or stocks, at the exact wrong times.

If you combine these two culprits and you make the wrong investment decisions at the wrong times and allocate capital to the wrong areas of the markets, its easy to see why investors have such a hard time earning a decent rate of return.

 

GMO Forecast

GMO is one of the larger and more well-known money management firms that manages over $116B in assets. Periodically, they release their forecasts for the 7-year average returns of various markets within the stock and bond asset classes.

You can see from this chart that GMO believes the only places to earn a positive rate of return over the next 7 years is in emerging market stocks and bonds as well as timber. GMO also forecasts that US “high quality” stocks will deliver a slightly positive return each year as well.

Every other asset class is expected to lose money going forward. You can also see from the chart that the long-run average return for US equities is 6.5% each year.

Over the last 5 years, US equities have returns 15% a year, more than double the long-run average. So, its not surprising that markets would need to mean-revert and have lower returns over the next 5 years in order to move back towards the long run average.

 

What To Do

We’ve already discussed the fact that investors inherently make bad decisions which leave them earning far less than the market opportunities that are presented.

Based on the RBA study, during a 20-year period of time where the S&P 500 earned 9% per year, the average mutual fund investor earned less than 3%. And as of the end of March, GMO is forecasting that the opportunity set in US equities over the next 7 years, wont’ be 9% a year, or the 15% a year we’ve seen recently but rather an annual decline of 2%.

So what is an investor to do?

The key to capturing above average returns is to have a time-proven process that consistently puts you on the right side of market moves with trades that skew the risk-reward in your favor. The reason it's important to have a “time-proven” process is that inevitably you will under perform and it's important that you have the confidence to stick with your process. 

For instance, take the current year to date return of TWR trade ideas. I’m not happy at all about being down over 6% to start the year. But I know that draw downs and consecutive losing trade ideas are to be expected within the context of my process.

My understanding of the time proven process that I’m using allows me to have the confidence that my process will extract value from the 8 Focus Markets we trade.

Over the last 1 and 2 year time periods, TWR has handily outperformed mutual fund and hedge fund averages. And it has done so with less than 1 trade per week over the 124 weeks I’ve been publishing TWR.

So, in that context, a 4-month period of under-performance isn’t concerning to me. Having a time-proven process helps me to manage my own cognitive biases which could lead me to make poor decisions which impact my returns negatively.

Utilizing a time-proven process can do the same for you. It can help manage your emotions and make sure you making decisions based on a framework that has proven to deliver excellent results consistently.