McLean Heuristics

The incredibly volatile year of 2011 is in the rearview mirror, and many of us are grateful for that. When thinking about how to sum up the year that was, Occam’s decided we would offer James Surowiecki’s version from The New Yorker. His latest article in the current edition of The New Yorker magazine reviews 2011 and challenges the core questions of equity investing.  We end this piece with our concluding thoughts and an expanded discussion of one of his core points.

In 2011, the S. & P. 500 finished the year where it started. (To be precise, it fell 0.003 per cent.) But it was anything but a placid year in the stock market. Instead, there was extraordinary tumult throughout 2011, with a series of sharp rallies and brutal selloffs, the biggest of which sent the market down seventeen per cent in a couple of weeks. Even on a daily basis, stocks were startlingly volatile:  the Dow Jones Industrial Average moved more than a hundred points on forty per cent of trading days, and there were more than sixty days on which the S. & P. index moved about two per cent or more (which in 2005, for example, it didn’t  do once).  Ordinary investors, who have watched the value of their 401(k)s yo-yo seemingly at random, have been left feeling understandably dazed and confused as they head into the new year.

Traders and professional money managers don’t seem to have any real clue about what’s going to happen, either. You might think that volatility would allow people with superior information and market sense to get ahead. But last year money managers did a very poor job of playing the market. According to estimates made by Goldman Sachs, as of the last week in December seventy-two per cent of core large-cap mutual funds had underperformed their market indexes. The average stock-market mutual fund was down almost three per cent for the year. And hedge-fund managers, who are supposed to thrive on volatility, did even worse, with hedge funds that focus on stocks falling more than seven per cent. Strikingly, some of the biggest flops came from superstars: Bruce Berkowitz, whom Morningstar named one of the money managers of the past decade, saw his flagship fund fall more than thirty per cent; the hedge-fund manager John Paulson, whose bet against mortgage-backed securities a few years ago has been called “the greatest trade ever,” saw one of his funds drop nearly fifty per cent.

To make matters worse, the raw numbers for 2011 probably understate how badly ordinary investors fared, because they don’t account for our tendency to chase performance. As myriad studies have shown, investors often put their money into funds that have enjoyed recent success and take it out of funds that have been struggling. This seems logical, but, since most of a money manager’s performance, particularly in the short term, is the result of luck rather than of skill, this means that people often end up in funds that are about to go cold and leave ones that are about to do better. One study that looked at investor returns between 1991 and 2004 found that trading in and out of funds cost investors in actively managed mutual funds 1.7 per cent annually,  and a Phoenix Investment Partners study that looked at rolling returns between 1990 and 2000 found that buying high and selling low cost investors twenty per cent of their returns over the decade. Hedge-fund investors, though supposedly more sophisticated than your average Joe, pay a similar price for chasing performance. Investing in actively managed mutual funds or in hedge funds already reduces the chances of beating the market, since, according to Vanguard, over the past decade more than sixty per cent of actively managed mutual funds underperformed the S. & P., while hedge funds have trailed the market since 2003. But the search for the hot hand takes a bad situation and makes it worse.

The sensible solution would be for investors to put their money into low-cost index funds and just keep it there. But that’s hard to do when the market is extremely volatile. Most of us find it difficult enough in normal times to take a long-term approach. So when prices are rising and falling two per cent a day, and when it seems like getting in or out of the market could be worth ten per cent of our portfolio’s value, the temptation to try to time the market is hard to resist.  (The way the financial media covers the stock market—with each rise and fall treated as a major event—only exacerbates this problem.) Unfortunately, the same psychological forces that make investors bad at rating money managers also make them bad at market timing: all else being equal, they’re prone to sell at the bottom and buy at the top. And, the bigger and more dramatic the swings in the market, the more likely we are to make the wrong decision.

In other words, while crazy volatility may be great for traders (who live for the chance to make two per cent a day), it’s lousy for the rest of us, and for the economy as a whole. It isn’t just that volatility costs ordinary investors money. It also makes them more likely to give up on the stock market entirely: over the past three years, investors have pulled almost two hundred and fifty billion dollars out of equity funds, even though stock prices have almost doubled since the lowest point of the crash. And, while some of that money has gone into exchange-traded funds, most of it has just left the market. This flight from stocks is probably not a good thing for people’s retirement accounts—after all, in a capitalist country owning some capital is usually a smart way to make money. But it may well be a good thing for investors’ psychological well-being. In effect, they’ve decided that, in a market as volatile as this one, the only way to win the game is simply not to play.

James Surowiecki makes several great points in this piece about the failures of active management; the fallacy of hedge funds (whose exclusivity and lack of transparency doesn’t make them smarter than the collective wisdom of the market); the merits of low-cost index investing; and the psychology of volatility. It’s his last point, although presented in a somewhat defeatist manner, that deserves more discussion.    

Risk and return are related and you must be willing to accept some level of risk in order to achieve your investment goals. Risk is synonymous with volatility and volatility is positively correlated to the amount of equity exposure in your portfolio. Over the long term, i.e. many decades, higher volatility portfolios should produce higher returns. Most go-it-alone investors never realize these higher returns simply because they don’t have the emotional wherewithal to remain myopic and focused on their plan, assuming they have one. Establishing an emotional barrier to financial decision making is in and of itself reason enough to hire a  professional advisor. An even more compelling reason to seek professional advice is based upon the findings of research firm Dalbar Inc.  

Dalbar Inc. is a company which studies investor behavior and analyzes investor market returns. The results of their research consistently show that the average investor earns below average returns. For the twenty years ending 12/31/2010 the S&P 500 Index averaged 9.14% a year– a pretty attractive historical return.  The average equity fund go-it-alone investor earned a market return of only 3.83%, simply because investor behavior is the mirror opposite of the business cycle.    

Your optimal asset allocation is mathematically based upon your needs, time horizon, contributions, etc., but it is worthless if volatility causes enough anxiety to drive your decision making. After all, risk tolerance is a psychological trait that is a relatively enduring way one individual differs from another. Therefore, the advisor-client relationship must inherently be personal so that your advisor truly understands your emotional connection to volatility. 

 As Mr. Surowiecki points out, many investors in 2011 decided not to “play the game” and removed themselves from the market completely. In some cases, they have permanently damaged their retirement future.  The prudent decision would have been, and continues to be, to assess if the proportion of fixed income (bonds) in your portfolio is high enough to sleep well at night, allowing you to remain focused on your plan.  

REFERENCES:

“Year of the Yo-Yo,” The New Yorker, January 16, 2012. Written by James Surowiecki.