Why You’re a Lousy Investor and Don’t Even Know It
Why You’re a Lousy Investor and Don’t Even Know It
Has a better piece of advice ever been ignored more often than “don’t try to time the market?”
Oh, sure, index funds have made huge strides in recent years. Investors even have fancy new weapons dubbed “smart beta” in their arsenal to supposedly do a bit better than just tracking baskets of stocks or bonds. Yet we are as far as ever from low-fee, market tracking Nirvana.
All these smart innovations somehow haven’t kept smart people from doing dumb things with their savings.
It sounds strange, but the “average” investor lags the average return by four to seven percentage points per year—sort of like the children of Garrison Keillor’s Lake Wobegon in reverse. Even more than high costs, the surest path to Lake Moneybegone is zigging when you should zag. Investors are constantly under the false impression that they or some vaunted expert knows something that will help them gain an edge.
Unfortunately, people in the prediction business aren’t very good at it. The old joke says that economists were invented to make weathermen look good. But what if you had a 100% accurate way of knowing what lay ahead for the economy? Surely it would be like pure gold. That idea is so wrongheaded that we have to turn to fiction to debunk it.
Book Excerpt
Adapted from the forthcoming book “Heads I Win, Tails I Win” by Spencer Jakab to be published by Penguin Random House on July 12.
ENLARGE
In “Back to the Future Part II,” Marty McFly and Doc Brown travel 30 years into the future to the year 2015 to prevent Marty’s son from committing a crime and going to prison (Marty went 30 years back to 1955 in the first movie). While walking around the future Hill Valley, Marty buys an antique sports almanac covering the years 1950 through 2000. It turns out to be a very bad idea. Doc convinces him that he risks wreaking havoc by using it to enrich himself and jeopardizing the space time continuum.
Before he can get rid of the book, though, his now elderly nemesis, Biff, sees Doc’s DeLorean time machine parked on the street. Unbeknownst to Doc and Marty, he borrows it to make a quick round trip to 1955. Meeting his teenage self, he hands him the almanac. After Doc and Marty accomplish their mission, they return to 1985 to find a dystopian world dominated by a fabulously wealthy and corrupt Biff.
Given the far greater sums available by betting on stocks, though, whispering names like Apple and Microsoft into teenage Biff’s ear seems far more valuable. Let us pretend instead that old Biff does the next best thing and gives him an economic history book with the dates of every upcoming recession.
Biff would sink all of his savings into the stock market and pull it out the day before a downturn began. This would be months before economists realized it. Companies pay millions of dollars for forecasters to get it right, yet they never do. The same goes for identifying the end of a recession, at which time Biff would boldly dive back into the market with uncanny prescience.
But fast forward (or is it backward?) to 1985, and all Doc and Marty find is a very frustrated Biff. Even ignoring taxes and fees, a $10,000 investment in 1955 would be worth $122,000 by 1985 invested this way rather than $149,000 if Biff had just let his money sit untouched in stocks.
Biff’s problem was that he sat out some awful times but some awfully good ones too. For example, the annualized return over that whole period for the S&P 500 and its predecessor index was 9.6%. But a new bull market usually starts when a recession is still under way, and it is with a bang, not a whimper. The annualized return between the start of a new bull and the end date of a recession is around 70%.
Rely on another statistic like unemployment rather than economic growth, and you won’t do any better. Between 1933 and today, the three-month period before the jobless rate peaked in each recession had fantastic returns. Just owning stocks during 14 such episodes strung end-to-end, a period of three-and-a-half years, would leave you with seven times your money. Shying away from the market during what seem like bleak times will open up a yawning gap between what you are and should be earning.
Ah, but there is no such thing as a flux capacitor so, even if your timing happened to be uncanny, you probably wouldn’t get it exactly right. And, if you are like the typical investor, you would get it mostly wrong by just trying.
Investors are way off in their estimate of how their portfolio has done, routinely guessing several percentage points a year too high. While that comes as a shock, they are even more surprised to be told that it is missing good times rather than suffering through selloffs that hurt them the most.
Like Biff, investors sit out on some really good days by trying to avoid bad ones. Nearly all of those happen around scary episodes such as October 1929, October 1987 and in 2008 following the collapse of Lehman Brothers. Pretend, for example, that you took your money out of the market following the choppiest episodes over the last 20 years and wound up missing the epic rebounds that made up the 40 best days. You actually would lose money. A couple of days a year on average produce all of the market’s return.
Happily, there is one form of market timing that has worked like a charm over the long run. It only does, though, if you take not only expert opinion but your own opinion out of the equation. Biff never really had a chance. You, on the other hand, have a very good one using low-cost, passive funds rebalanced on autopilot.
The key is to stop shooting yourself in the foot.
Adapted from the forthcoming book “Heads I Win, Tails I Win” by Spencer Jakab to be published by Penguin Random House on July 12.
Write to Spencer Jakab at spencer.jakab@wsj.com
