You are your portfolio's worst enemy

Marketwatch

Fund shareholders should know what bad investment behaviours look like. To find them, most people simply need to look in their own portfolio.

Whether it’s buying funds with above-average expense ratios or chasing performance by rotating toward hot funds -- instead of trying to “buy low” by purchasing whatever the market has put on sale -- hyper-actively managing a portfolio, or going for money managers who haven’t proven capable of living up to their fund’s promises, there’s hardly anyone out there who without one or two classic blunders thrown into their investment history somewhere.

The question is whether that’s actually so bad.

That question was raised for me most recently by some new research by the Vanguard Group -- the world’s largest fund company -- on the effects of performance-chasing.

The report analyses “more than 40 million return paths” to cover every possible trade that could have been made among diversified domestic stock funds from 2004 through 2013. Vanguard used a three-year holding period, because that is roughly how long the typical investor hangs onto the average equity fund.

Effectively, the research assumes that anyone whose fund delivers below-average performance over three years would dump the lagging fund in favour of something that has done better in the same asset class.

It’s not a real surprise that the trading investor -- the one who gives up on a fund after three years to buy something “better” -- does worse than the one who overcame their disappointment to let the money ride.

The differences are big, too, with buy-and-hold delivering a 7.1 per cent average annualised return in large-cap growth, for example, compared to 4.3 per cent for a performance-chasing strategy.

There’s some fault in the methodology. I have seldom heard from an average investor who was interested in swapping a lagging large-growth fund for another one in the same asset class; normally, they’re so disappointed with results that they are dumping the fund and either rebalancing or just going for what’s been hot lately. That’s why so many investors left stocks as the financial crisis of 2008 was unfolding, moving into bonds and, in many cases, missing out on the subsequent bull market as a result.

There’s not much fault, however, with the conclusion that investors typically hurt themselves by trading, rather than helping themselves.

Now we could argue the reasons that investors make mistakes; because they’re irrational, not particularly knowledgeable and more. We can show that the numbers suggest that they would “do better” if they invested in lower-cost funds and held them for a long time.

But just because it’s right doesn’t mean the average investor can do it.

Intuitively, by now, investors know that buying index funds makes sense, because so few money managers consistently beat their benchmark.

But buying an index fund is a bit like riding a rollercoaster in the amusement park; you may know that the coaster is the biggest, best ride, but plenty of people simply can’t buckle themselves in and take the ups and downs.

Right or wrong, using an active manager instead of an index fund gives many of those people a sense of controlling their downside risk. If they are able to buy-and-hold the active fund -- when a downturn might convince them to bail out of the index -- then their results are likely to be better in an active fund, regardless of what any study says about which is the “best investment”.

Simply put, some people would rather ride the ferris wheel and the carousel, others want only the coasters, and still others want to ride everything. All can have a good time in their own way doing the same thing in the investment theme park.

What most of these studies miss is that no one actually sets out to make investment blunders; most of the time, you are looking at honest mistakes.

If those errors blow up the portfolio, it’s a disaster; if they result in “sub-optimal returns,” it’s more like an unfortunate circumstance.

“People are given the tools to hurt themselves on a daily basis these days,” says Karl Mills, president of Jurika, Mills & Kiefer in San Francisco. “Your portfolio can tweet at you now. You get messages about every market move and you can have stock advice sent to your phone. The temptation is to do something which almost always will backfire on your long-term thinking.

“For a lot of people, they keep hearing ‘this will help you’ and ‘this will make your portfolio better,’ and they look at this like ‘I’m making my portfolio better,’ even if they’re not,” he added.

In short, investing is like the proverb in which perfect is the enemy of good.

If you are always in search of something better, there’s a good chance you’ll hurt your portfolio precisely by doing things you expect to help it.

So long as you reach your financial goals -- whether it’s because of those manoeuvres or in spite of them -- and you can sleep at night along the way, that’s OK.

Having “the best results” is less important than having a strategy that is “good enough” for you.

This article was first published on Marketwatch.com. Click here to read the original article