Filed under: Investing
It's been a great year for investors -- or so you'd think. Over the 12 months ending Dec. 12, the S&P 500 (^GPSC), including dividends, is up 12.6 percent. A balanced portfolio of 60 percent U.S. stocks and 40 percent bonds, represented by Vanguard's Balanced Index Fund (VBIAX), is up 10.7 percent.
In a recent survey on investor satisfaction by investment firm SigFig, 38 percent of respondents said they were somewhat or extremely happy with their portfolio performance in 2014, and another 42 percent were neutral. Only 20 percent were unhappy with their portfolio.
Yet most investors' portfolios have underperformed both the S&P 500 and a balanced portfolio benchmark. The median investor in a data analysis by SigFig earned just under 4.5 percent over the 12 months ending Dec 12. The top quartile of investors -- those who enjoyed better returns on their portfolios than at least 75 percent of the crowd -- earned a median 12-month return of 16.5 percent. The bottom 25 percent suffered a median loss of 15.7 percent.
To state the obvious, no one wants to be in the bottom 25 percent of anything -- much less when it comes to one's current or future source of livelihood. And just to be clear, being in the top 25 percent doesn't mean your investment strategy is perfect, either. Chances are, you may have simply gotten lucky. Still, when we look at the investing behavior of the bottom 25 percent and that of the top 25 percent of investors, a few common mistakes emerge that are best avoided by everyone:
1. Higher Fees
The underperformers are paying more in trading and fund fees -- 1.1 percent of their portfolio value vs 0.6 percent for the outperformers. Still, that's not nearly enough to explain the difference in performance between the median "outperformer" and the median "underperformer." Paying an additional 0.5 percent in fees should knock down my portfolio's performance by 0.5 percent, not 31.4 percent.
2. Portfolio Turnover
Underperformers have more portfolio turnover -- 35 percent - than outperformers, with 18 percent. Higher portfolio turnover (i.e. more trading) has been linked to lower gains in multiple studies. And in this one, it is directly related to higher fees. As a percentage of their portfolio, the typical underperformer in the dataset pays 25 percent more in fund expenses, but more than five times in trading fees.
3. Playing Portfolio Roulette
Both outperformers and underperformers in the analysis had an equal percentage -- about 80 percent -- of their trades executed in individual stocks, rather than mutual funds or ETFs. Trading stocks is often like playing roulette with your portfolio: you may get lucky and win. Or you may lose. And winning doesn't mean you made the right bet: you may have picked a winning stock this time, but that is not a "winning" strategy for the long term. In the same way that betting on black at roulette may win a single spin of the wheel but will lose to the house in the long term, the evidence strongly suggests that selecting individual stocks can produce short-term outperformance, but will underperform the broader market over time.
A Matter of Overconfidence?
Meanwhile, in its investor satisfaction survey, SigFig asked investors, "How do you think your portfolio will perform next year?" About as well as the market, 72 percent of respondents said. Better than the market, another 18 percent said.
Now, beating -- or even matching -- the stock market is not a worthwhile goal in itself. People should invest according to their risk tolerance, which for most investors means a healthy serving of safer bonds along with riskier stocks. Comparing investor returns to market indices is also imperfect, because indices may be unmanaged, may be market weighted, and do not incur fees and expenses.
And if you don't want to be part of the majority of investors with unfounded great expectations, here are a couple of time-tested strategies that will help you invest better in 2015:
- Invest in diversified, low-cost index funds and ETFs.
- Avoid frequent trading, which is associated with lower performance.
- Don't try to time the market. Yes, some investors may get lucky. But to time the market successfully and repeatedly is hard. And it often involves bad investor behavior: selling out at a bad time or holding onto losing stocks even if they're only dragging your retirement savings down.
