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Learn how to avoid making the ‘big mistake’ with your investments
The majority of investors who make the big mistake make it more than once, despite sensing that their behavior is counterproductive.
At a November industry conference for optometrists in Philadelphia, I lectured about several mistakes investors make seemingly over and over again. Afterward, several members from the audience told me that one particular bit of information I presented clearly stood out in their minds: the difference between average investor performance (returns) vs. the performance of the S&P 500 Index measured between 1984 and 2002.
In my previous two articles on investor gaffes, I emphasized that it is investor behavior, not knowledge, IQ or even the investments themselves that orchestrate investor portfolio success. In most cases, it is the manner in which investors act when stressed by fear or overwhelmed with exuberance that is the ultimate determinant of their portfolio success. But how badly does investor behavior retard investor performance?
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At the Philadelphia conference, I presented a 2003 study by the Dalbar Institute that clearly exposed the damage emotions can inflict on portfolio success. Dalbar found that during the same period (January 1984 through December 2002) in which the S&P 500 achieved an annual compounded rate of return of 12.20%, the average investor managed a mere 2.60% annual rate of return. This trailed even the paltry measurement of the Consumer Price Index (CPI), which was 3.10%. Why? Well I’ve called it “The Big Mistake”, after financial writer Nick Murray’s discussion on the topic. Unfortunately, the majority of investors who make The Big Mistake, make it more than once, despite in many cases sensing that their behavior is counterproductive. Could that be you?
In past articles, I’ve written about mistakes such as the lack of portfolio allocation, trying to time the markets, falling prey to “best of” lists, failing to understand the difference between a loss and a decline, and other common, yet avoidable, investment mistakes. But a phone call from a New Jersey client recently focused my energies on listing a few more classic errors for your consideration – perhaps to help you avoid similar portfolio killers.
The phone call came in early fall 2006. My client was looking at his 401(k) account through work, as well two brokerage accounts through our office: one containing the Vanguard Index 500 Fund and the Washington Mutual Investors Fund, the other a fully-diversified managed account with various mutual funds. He vented out loud why there was such a huge difference in performance year-to-date among the accounts. He wanted to disband the diversified account because it trailed the Dow Jones Industrial Average (DJIA) and because it was a fee-based account. That phone call, and the emotional behavior displayed by this well-intentioned and intelligent client betrayed his purely subjective overview of his portfolio performance, and, I’m sure, if left to his own devices, would have resulted in his committing The Big Mistake. But it also gives me a practical list of new investment mistakes to present to you here, as my client was on the verge of committing several.
The growth vs. value dance
My client’s three accounts were diversified so that his 401(k) contained mostly large-cap growth funds, his basic brokerage account housed a significant tilt toward large-cap value (Washington Mutual) and his managed account was properly balanced between growth and value, large, mid and small cap, domestic and foreign, and fixed income positions (30%).
Historically, growth investment style and value investment style have been countercyclical when measured against the returns of the S&P 500. The pattern is unmistakable, when growth is up, value is down, and vice versa. The accompanying chart clearly demonstrates this patterned performance.
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Source: Ken Rudzinski, CFP, CLU, ChFC, CASL |
For the record, growth stocks typically pay little or no dividends, have high price/earnings (P/E) ratios and might be considered new economy stocks, whereas value stocks tend to be more old economy, pay reasonable dividends and possess lower P/E ratios. Moreover, growth mutual funds managers feed on market optimism about individual stocks or market sectors following a formula they call GARP (Growth At a Reasonable Price). They buy up and sell higher. On the other hand, value managers act on market pessimism and tend to buy undervalued stocks for their portfolios, ie, individual stocks or perhaps an entire sector of stocks currently trading below their intrinsic value, such as happened in 1993 when pharmaceutical stocks got hammered under the doomsday scenario of the Clinton Health Care Reform package.
Therefore, growth managers and value managers fish in different ponds, and the historical results of their relative performance tend to be at opposite poles. What’s even more interesting is that no one has an accurate crystal ball to determine when growth and value flip, as happened in 2006 when value style took off early, then growth style recovered later in the year.
My client’s 401(k) account consisted of mostly growth stock funds that trailed value funds badly through most of the year, whereas his basic brokerage account favored value, which was the dominating style when he called me. So the former account should have trailed the latter one, and it did. It’s just that he didn’t recognize that it was not the performance of the underlying mutual funds that made the difference, it was more the results of the investment style. The managed account was the odd-man out because it contained fixed income funds (30%) and wasn’t on the same playing field as 100% equity accounts, especially in an up-market.
Now here’s where investors, like my client, make this growth vs. value mistake. My client observed that his 401(k) Fidelity Contrafund (large growth) badly trailed his Washington Mutual Investors Fund (large value), and he was considering dumping his Contrafund. By December 31st, WMIF had outperformed Contrafund, 18.00% to 11.50% (the day he called the disparity was more stark). However, according to the Lipper Indexes, large value outperformed large growth 18.28% to 4.72% for the year. So Contrafund actually outperformed its like-kind index 11.50% to 4.72%, whereas Washington Mutual actually trailed its index, 18.00% to 18.28%. So which fund was the real winner for the year: It was Contrafund, not WMIF. He would have sold the better-performing fund because he was looking only at the 18.00% to 11.50% performance comparison while ignoring the results of growth relative to value styles for the year. Can you relate to this from your own portfolio management?
If you diversify your portfolio, you should expect that parts of that portfolio would perform differently from others. But, you also need to ensure that you compare relative performance on an “apples-to-apples” basis, ie, a growth-to-growth and value-to-value basis, to avoid this common investor mistake.
Think at the portfolio level
The investment choices in my client’s 401(k) were bad, except for Fidelity Contrafund and another mid-cap growth option. His basic brokerage account was in existence before we met and contained significant capital gains so it would have been painful to sell (due to taxes) to re-balance that account. His managed account was new so that balance was easily achieved.
Therefore, to establish portfolio allocation, we balanced across all the accounts (including some additional IRA and nonqualified accounts). In other words, only the managed account was properly balanced as an account, whereas the others deliberately favored one style over another. But taken together, the portfolio was in proper allocation and balance. Wilmington, Del. financial planner, Brent C. Fuchs, CFP, CLU, ChFC, said, “In my experience, investors usually have limited 401(k) fund choices, and many of them are inadequate. By blending the 401(k) account into the total portfolio allocation, the investor can pick the best from the available 401(k) choices, even if it’s only one fund, and balance the portfolio with non-401(k) investments accounts.”
So, think across your entire array of invested assets to achieve asset class balance. In that way you can achieve the desired result for the sum even though the parts themselves lack proper balance. Without that portfolio overview, you might be falling prey to the mistake either of trying to balance each account unsuccessfully, or achieving no global portfolio balance at all.
Batting average or slugging percentage?
When my client commented on the performance of his managed/ allocated account vs. his 401(k)/basic account(s), he was forgetting what I had told him when we established that managed account. I reminded him that a balanced, allocated account (portfolio), especially one with a sizable fixed income component, will perform more like baseball Hall-of-Famer Tony Gwynn, lots of singles and doubles and a pretty good career average. However, a targeted, sector-type account (portfolio) might perform like Mickey Mantle, with tape-measure homeruns in between a record number of strikeouts. My client also was making the mistake of comparing his various accounts to the narrowly focused DJIA, an index of only 30 stocks out of the entire equity-based universe numbering thousands, and one that ordinarily is not used for comparison as is the S&P 500. Where was your focus in 2006? Did you get distracted by the performance of the DJIA as a basis for comparison of your own portfolio?
Don’t make the mistake of expecting a record number of homeruns from your leadoff singles hitter or a .350 career batting average from your clean-up slugger. What have been your expectations from your portfolio?
An objective advisor?
Pardon my bias here, but many people are just not equipped to handle the emotional roller-coaster that is the stock market. And so they are set up to make The Big Mistake over and over, seemingly investing their money until it’s gone, or they “go conservative” and barely eek out a return greater than the CPI. Do you see yourself in one of these mirrors?
My client complained about the fee for his managed account as that account was underperforming the value-based account by several points. Yet he forgot that between 2000 and 2003, he was on the verge of demanding we liquidate his accounts at substantial losses (remember you only lose when you sell; otherwise, it’s only a decline). Like many investors, he needed an advisor to steer him away from making The Big Mistake and to keep him invested until the markets could recover, which they’ve done now nicely for three consecutive years.
Many investors see the fee they might pay to an objective, unemotional advisor as a substantial cost, as that is the position taken by many financial periodicals that suggest they should be your portfolio guide and chief financial counselor, all for a $2.50 per month subscription. In other words, a possible 8% portfolio return would be reduced to 7% for an account charging a 1% management fee. Perhaps so, but cost is just cost in the absence of value, and a good advisor can perhaps help you scale the difference between the 2.60% return of the average investor and the 12.20% return of the S&P 500, as revealed by the 2003 Dalbar study. So, maybe it might be 11.20% (net of the 1% fee) compared with 2.60%? Don’t know for sure, and certainly there are no guarantees of future market performance based on past history, but if your behavior is the main driving force for lowering portfolio returns over time, then perhaps it might be helpful to allow a seasoned investment professional to remove that all-too-human weakness from your investment equation. But that advice is not free (neither is the financial magazine). Is it worth it? It could be, you be the judge.
If you send me an e-mail request, I’ll forward you the excellent brochure, “Lessons For Life – Ten Concepts For A Better Financial Future.”
For more information:
- Kenneth W. Rudzinski, CFP, CLU, ChFC, CASL, as Certified Financial Planner in Wilmington, Del., has been cited in Money magazine and in “Who’s Who in Finance & Industry.” He can be reached at the America Group, 302-529-1320, or by e-mail at Kenneth.Rudzinski@lfg.com.
- Lincoln Financial Advisors Corp., or its representatives, do not give tax or legal advice. The information in this article is from sources deemed reliable. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances.
- Kenneth W. Rudzinski is a Registered Representative of the Lincoln National Advisors Corp.
- Securities and advisory services offered through Lincoln Financial Advisors Corp. a Broker/Dealer (Member SIPC) and Registered Investment Advisor. Insurance offered through Lincoln affiliates and other fine companies. CRN200701-200221