Why the dead outperform the living

Do dead people really make the best investors? With inactivity and a lack of bias working in their favour, they just might.

If you want to be an above average investor, it may pay to play dead. That was the conclusion of a study by US fund manager Fidelity, according to a 2014 article on Business Insider. Fidelity analysed thousands of client accounts and broke them down into percentiles, trying to figure out what the top performers had in common. The result: the best investors were either dead or had forgotten they had an account.

Unfortunately, I've never been able to locate the original study and Fidelity doesn't seem to remember it either. The story is probably a hoax. But plenty of other research comes to the same conclusion: activity is the assassin of returns.

A University of California study of 66,000 investors found that the higher a portfolio's turnover, the lower the average return. Those who traded the most lagged the overall market's performance by 6.5%. As the researchers put it, ‘trading is hazardous to your wealth'.

The reason is pretty simple: impatience adds ‘frictional costs'. For anyone who shuns a 'buy and hold' philosophy, brokerage fees and taxes quickly bite into their returns. The nature of compounding means that small disadvantages in any one year – that may seem trivial at the time – can take a big chunk out of your final payout.

Curiously, the University of California study found that high turnover correlated with underperformance in both taxable and tax-deferred accounts – there seems to be more at play than mere frictional costs. The researchers suggest the culprit may, in fact, be mental: overconfidence.

We tend to overestimate our own abilities – our confidence in our predictions is generally greater than their accuracy. This is then exaggerated by another cognitive mishap called confirmation bias. Once we form an opinion we tend to search for and interpret information in a way that's consistent with it.

‘Overconfident investors will overestimate the value of their private information, causing them to trade too actively,' the authors suggest. Overconfidence can cause you to buy and sell at the wrong time; mistakes and frictional costs then pile up.

How to play dead

  1. Focus on long-term fundamentals: If you're investing for the next 10 or 20 years, try to ignore short-term price movements. Whether your stocks went up or down 3% today probably doesn't matter. What does matter is whether the company is strengthening its balance sheet, building its underlying earnings power, and whether it has a sustainable competitive advantage.
  2. Take your time and play devil's advocate: Feeling that you need to act on advice immediately is big no-no. The business news is specifically designed to get you excited so that you continue reading, and the more news you consume the more likely confirmation bias and overconfidence will lead you to trade too much. Before making a trade, sleep on your decision for a few days and try to think of the counter-arguments to your investment case. When in doubt, do nothing.
  3. Hold on to great businesses: Wonderful companies can end up creating value over time in surprising ways, whether through internal investment or acquisition. Often it's simple mathematics. Companies that can reinvest capital at high rates of return can compound value significantly over time'. 

Perhaps the best way to counter overconfidence is to always leave a margin of safety between the price you pay and the intrinsic value of the stock to allow for mistakes. If you own a collection of great businesses, bought when they were undervalued, and hold them for the long term, you're bound to do well.

‘The biggest thing about making money is time,' Warren Buffett says. ‘You don't have to be particularly smart, you just have to be patient.' 

 

The original article was published on 20 July 2017.


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