Let’s face it, successful investing is hard. I’ve spent much of my adult life in a library or head down in a financial textbook trying to “figure out the markets”. But over time (and many lessons learned) you start to develop a framework and base of investment knowledge, helping to increase your odds of investment success. It’s no wonder then why the “average” retail investor so badly underperforms the market.
According to an influential study called the DALBAR Annual Report of Investor Returns, the average investor greatly underperforms the S&P 500. This, in part, is why we recommend investors buy inexpensive index-based ETFs rather than those expensive and often ineffectual mutual funds.
Over the last 20 years the average US mutual fund equity investor has returned a disappointing 4.67% annually versus the S&P 500 at 8.19%, resulting in an underperformance of 3.52% annually. While the study focuses on the average US investor, I’m confident the Canadian experience is much the same.
Given this reality what is an investor to do when the odds seemed stacked against them?
In this week’s post we examine the factors behind this underperformance and suggest ways to help mitigate against this undesired investment outcome.
The DALBAR annual report, which costs US$775 or a cool US$10,000 plus travel expenses for a one-hour presentation, can be summarized by these two lines taken directly from their website: “Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market.”
More specifically the report cites three main reasons for the return underperformance: 1) a lack of capital and/or need for cash; 2) high management fees; and 3) investor behaviour.
In the table below we show the percentage contribution to the underperformance from these factors. The lack of available cash, and need for cash, contribute a combined 1.22% annually to the underperformance. On this particular factor I can add little advice on how Canadians should save more, other than to say that all Canadians, rich and poor, should have a monthly automatic savings plan which debits your bank account automatically for a set dollar amount every month.
Often people say they will save whatever is left over in the month. But there rarely is anything left over at the end of the month, especially given our inflated home prices, anemic income growth, and record debt levels here in Canada. So pay yourself first by debiting your bank account and investing those proceeds. Here I practice what I preach having an automatic savings plan going into my TSFA, which is how I ensure that I’m saving each month, and topping up my TSFA account (so important!). So to ensure you have money to invest as opportunities arise, use a monthly automatic savings plans by depositing money into your investment account each month.
Source: DALBAR Annual Report
The second important factor behind investor underperformance is high management fees. Here my solution is easy – have an advisor who charges a reasonable fee to manage your money (shameless plug, we charge clients a low, tax-deductible management fee of 1%) and who only invest in low-cost index-based ETFs. Since it’s near impossible to “beat the market” over the long-run, why bother paying some million dollar per year salaried Portfolio Manager who charges 2%+ and rarely delivers any alpha (return over the benchmark).
Currently, our ETF model portfolio has an average MER (there are nominal MERs with ETFs) of just 28 bps. So a client of Turner Investments pays an all-in cost of 1.28%, which again is partly tax deductible and includes other services such as tax and financial planning, on top of the investment management.
In contrast, similar balanced products from the banks and mutual fund companies cost 2%+. For example, the TD Comfort Balanced Growth Portfolio and Investors Group Canadian Balanced Portfolio come with an annual MER of 2.02% and 2.41%, respectively. Now if they are providing “alpha” then you could justify paying the higher fees (spoiler alert: they’re not).
To put this into perspective I ran some numbers looking at the impact on a portfolio paying a 1% fee versus 2%. For a $500,000 portfolio compounded over 20 years at a 6% gross return, the 1% fee portfolio would grow to $1,324,817 versus the 2% fee portfolio at $1,092,403, resulting in a difference of $232,415 in lost savings! And of this $232,415 in lost savings, $137,604 would go to the fund company or bank charging the 2%.
The Canadian banks made a profit of over $35 billion dollars in 2015. Do you really need to give them an additional $137,604 in fees over the next 20 years?
The last and most important factor to investor’s underperformance is investor behaviour. Broadly, this refers to mistakes investors make due to psychology, or behavioural biases. In the report it sites nine common behavioural biases, but we’ll focus on the two main ones – herding effect and loss aversion.
Herding effect refers to investors following what everyone else does (e.g., buying last year’s hot mutual fund or finally investing in the stock market late in the bull market). Loss aversion refers to a fear of loss in capital which often happens at the worst time or near the bottom of a bear market.
To help control these natural human emotions/behavioural biases, I suggest the following: 1) build a balanced and diversified portfolio which will lead to smaller drawdowns thus reducing the odds that you’ll capitulate and sell everything at the bottom; 2) rebalance your account 1-2 times per year, which helps you to remain disciplined and stay invested, while systematically have you trim winners and add to underperforming assets; and 3) remain laser-focused on the long term, since history clearly shows that over the long run equities and balanced portfolios will deliver the returns most need to retire comfortably.
To hit home this point, below is a table showing that the worst rolling 1-year total return in the S&P/TSX has been -39.2%, but as you extend your holding period to 10 years and beyond, there has never been a negative outcome based on rolling monthly periods. And as you lengthen your time horizon you get closer and closer to an average long-term total return of 9-10%. So don’t panic and sell at the bottom of inevitable bear markets. Instead, rebalance your account, add to your investment portfolio from your savings, and wait for the recovery.
So the question remains, “what’s 1% worth to you?”
Rolling Monthly Returns for the S&P/TSX Composite