Editor's Note: the following is a guest post by Josh Brown, CEO of Ritholtz Wealth Management. You can find Josh's work here and here.
Investors learn important truths, but we sometimes choose to suspend this knowledge when it feels better not to be encumbered by it. As an investment advisor, I come into contact with this phenomenon on a daily basis. No one is immune to it, myself included.
Below are seven essential truths of investing that we are all aware of, but cannot accept at all times, no matter how much evidence we’ve seen.
1. Anyone can outperform at any time, no one can outperform all the time.
There is no manager, strategy, hedge fund, mutual fund or method that always works. If there were a constantly winning way to invest, everyone would immediately adopt it and its benefits would be quickly arbitraged away. No one and nothing stays on top forever; the more time that passes, the more likely you are to see excess returns from a given style of investing dwindle. Until it becomes so out of favor that no one’s doing it anymore. That’s when you should get interested.
Investors understand this truth intellectually, but they don’t accept it. See here and here.
2. Persistence of performance is nearly non-existent.
In business, we like to bet on winners and go with what’s working now. On the field of play, we like to get the ball to whichever of our teammates seems to have “the hot hand.” While we are usually rewarded for this behavior in real life, we are penalized for it in the stock market. Because there is absolutely zero correlation between a manager’s past or recent performance and what may happen in the future. The outperformers of last year are equally likely to outperform next year as they are to underperform, statistically speaking. There’s literally zero rhyme or reason, even though emotionally we always want to bet with and be aligned with today’s champion. Are here exceptions? Sure, there are - but not many. You constantly hear about the few dozen managers who’ve beaten the odds and consistently outperformed, you hear almost nothing about the millions who’ve tried and failed.
Investors understand this truth intellectually, but they don’t accept it. See here and here.
3. Taxes and commissions matter.
99 percent of the people you will have market discussions with will refer to before-tax returns, and often they discuss investments gross of fees and commissions. The effects of these two constant costs cannot be overstated - they can reduce a strategy that looks fantastic on paper to a complete debacle and they frequently negate market edges and alpha once factored in. You can’t eat pre-tax returns and the friction of a fund’s internal expenses or your own trading costs will have a big impact on your real-world results.
Investors understand this truth intellectually, but they don’t accept it. See here.
4. Smart doesn’t equal good.
Everyone on Wall Street is smart. Like everyone in the NBA is a great ballplayer. Now what? The smartest guy in the room will not produce the best investment results. No matter how much research he’s done or how good his spiel is on a stage. In fact, some of history’s most spectacular flameouts involved geniuses and Nobel Laureates. This is because nobody - no matter how brilliant - knows what’s going to happen in the future and randomness plays a massive role in everything, investable markets and the economy included.
Investors understand this truth intellectually, but they don’t accept it. See here and here and here.
5. Incentives matter.
Everyone has to earn a living. Figure out how an investment management person gets paid and what drives their compensation and you can often work backwards to determine how their incentives may affect you. There’s nothing wrong with an advisor or a fund charging for their services, so long as the consumer understands that this will lead to certain biases and conflicts that are ever-present and eradicable. The self-interest of investment professionals can manifest itself in many ways, from their proclivity to recommend transactions to their allegiance to a particular fund family to their opinions on the future promise of a given geography, sector or asset class. Charles Schwab wants you to think your active trading is going to help you, Vanguard wants you to think you should never place a trade so long as you live. Everybody has an axe to grind, yourself included, and people’s opinions are almost always colored by what’s best for them personally.
Investors understand this truth intellectually, but they don’t accept it. See here.
6. The crowd is always at its most wrong at the worst possible time. Over the long haul, only one thing is certain - there is no worse performing “asset class” than the average investor. In the aggregate, investors underperform value stocks, growth stocks, foreign stocks, bonds, real estate, the price of oil, the price of gold, and even the inflation rate itself. Nothing underperforms the investor class. We know this from studying dollar-weighted returns, a glimpse into not just how an investment performs but in how much actual money had been gained or lost by the people who invested in it. On the whole, we bet big on assets that have already gone up a lot and sell out after they’ve gone down. We allocate heavily toward star managers just as their performance is about to revert to the mean - and we even pay up for the privilege. This is the eternal chase and it is as old as the hills.
Investors understand this truth intellectually, but they don’t accept it. See here and here.
7. Fear is significantly more powerful than greed. Behavioral science has proven that we feel anguish over losses much more acutely than we feel joy over gains. As the surviving scions of a hundred thousand years of human evolution, we can literally point to this risk aversion as the primary reason our ancestors managed to pass on their DNA while so many others did not. As the descendants of the more cautious members of the species, therefore, we are genetically hardwired to act quickly when we feel threatened - and this extends itself to our most precious modern resource, our money. That’s why markets drop much more quickly than they rise.
Investors understand this truth intellectually, but they don’t accept it. See here.
7 (a). There is no pleasure without the potential for pain. Adjusted for inflation and taxes, the average annual return for stocks going back to 1926 is approximately four times greater than the return for ultra-safe bonds. Why? Because by investing in stocks, you are assuming more short-term risk and accepting greater volatility today. As a result, you are being rewarded in the future. It cannot ever be otherwise, this relationship between short-term risk and long-term gain is both elemental and incontrovertible. Wall Street makes the majority of its money by convincing its customers that this rule can be skirted, manipulated or defeated. People will pay anyone nearly any amount of money who promises them all of the ups with none of the downs. Despite the fact that, in the fullness of time, this cannot possibly be achieved.
Investors understand this truth intellectually, but they don’t accept it. See here.
***
In moments of exhilaration or panic, all of us have done things that run completely counter to some or all of the investing truths laid out above. You have and so have I. The bad news is that we probably will again. The good news is that, with awareness, we can become better investors over time.
Not all of us, of course, because this is a zero-sum game and someone has to lose. Without widespread denial of these seven truths, there wouldn’t be a market to invest in at all.
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