Why the dead outperform the living
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
- Focus on getting your diversification right: The easiest way to sleep at night is to have your eggs spread into multiple baskets. Diversify across multiple asset classes and within asset classes. Exchange traded funds are a great way to get instant diversification and remove company specific or sector specific risk. Get your diversification right and for your investment time horizon and accept markets will at times be volatile.
- 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.
- Hold on and be disciplined when you add or draw down funds: Instead of jumping in and out of your investments develop good investment habits. Take a systematic approach to buying more shares as you save. Or, if you are already retired and no longer saving you can still take a systematic approach to how you draw upon your cash. Here’s a strategy we recently wrote about to help with exactly that.
Perhaps the best way to counter overconfidence is to look forward and always think about your investments with a long-term view. What will the world look like in five or ten years’ time?
‘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.