Tag Archives: Morningstar Investor Returns

Why We Trumpet Our Worry

Many clients and prospects who meet with us ask why we’re so pessimistic. There are a couple of reasons. First, although we don’t set out trying to be pessimistic, we report economic numbers and security valuations the way we see them. Bonds are giving poor yields, and stocks are at nosebleed valuations on any reasonable metric — Price/Sales, Shiller PE, etc… Consumer debt is high, as the middle class tries to maintain it standard of living on stagnating wages by borrowing. Economic growth since the last recession has been tepid. There’s no way to sugar-coat that, so we don’t try. We owe our clients our honest opinions.

The other answer has to do with managing investors’ behavior. We have a lot of collective experience in the financial services business, and we’ve seen investors make a lot of mistakes. And, yes, we’ve made a few ourselves, because we’re not perfect. Undoubtedly, we’ll make more. But our experience tells us that investors sell at bottoms. Everyone in our business knows this is a classic problem. Morningstar investor returns data often show that there is a 2 percentage point gap between mutual fund returns and the returns fund investors capture, though the last report Morningstar issued on this subject was admittedly more hopeful. If we are pessimistic it’s because we are trying to let investors know the stock market usually provides a bumpy ride, and tests your patience. It delivers gut-wrenching declines at times, and we prefer to see investors not sell during those declines. In fact, we want to prepare our clients so well for declines that they have a bias towards buying stocks when markets swoon.

All advisers want what we want; we are not unique in wanting to see our clients not sell at the bottom. The question, then, is how to combat the inherent urge to sell at the bottom. One possible tactic is to inculcate a buy-and-hold mentality in investors, and that’s a reasonable approach. But, although it doesn’t have to entail this, that approach often glosses over how painful declines can be, or just counsels investors to fight through them. That’s likely what investors should do, but telling them to grit their teeth may not be the best strategy to get them to do that. The buy-and-hold message emphasizes that investors usually come out better on the other side of a big market decline at the expense of focusing investors’ attention on how they might feel during the decline when they are likely to do the most damage to themselves.

We’d rather focus investors’ attention on how they might feel during the depths of a decline, and say to them,

The last two market declines have consisted in 50% drawdowns, so forget about the market’s long-term 18% standard deviation. You will be inclined to behave badly when you see your portfolio value declining, if you don’t think hard about that moment now when you’re more calm. You will want to sell everything to stop the losses instead of buying at cheap prices. And that will lock in your losses and potentially cause you to miss the eventual upswing. You will likely do yourself permanent damage. You will focus on how much your account has declined instead of focusing on how cheap stocks might be at that moment, and if you get too much stock exposure now you will not be inclined to buy at that moment. You will want to fire us as advisers, and you will never want to invest in stocks again. Or you will find an unrealistic and/or unscrupulous adviser who will tell you they can deliver all the market upside with none of the downside.

Try to remember how you felt and behaved in 2008-9, and then consider how much stock exposure you really want to have. We will do our best to manage your downside, but much of your success depends on your choosing an appropriate amount of stock exposure to begin with. That amount is usually less than you think it is, especially after a 9-year bull market.”

We think saying these things, and working hard to assess a new client’s risk tolerance, are more effective than emphasizing coming out on the other side of a bear market. Coming out on the other side isn’t the problem; the decline is the problem. Investors can’t see their way to coming out on the other end in the middle of a bear market, and encouraging them to do that at that moment isn’t helpful. We’d rather address bad behavior at a moment when investors — especially retirees, who are most vulnerable to fluctuating account — are in a better psychological state to listen.

We encourage investors to access the fear they’ve felt during past declines, before the next one ensues, and we never shame them into owning more stocks than they can handle. We think a lot of advisers subtly shame investors into owning more stocks because of how stocks have performed over the last century or so relative to bonds. Much of these gains owe to a price multiple expansion that was likely a one-time event during the 1908s and 1990s, as Rob Arnott and Peter Berstein have argued. And there are long periods when stocks have delivered poor returns.

No adviser knows exactly when bottoms and tops occur, but an adviser with experience can often judge the psychological temperature of clients well. An experienced adviser can often surmise how clients will react under different market conditions better than clients themselves. Clients are notoriously poor judges of how they will behave under adverse market conditions. They tend to block out how they felt in 2008, for example. And they are poor judges of how much stock exposure they can handle.

Clients will have to assess for themselves which approach and which kind of adviser will help them withstand market volatility, and help them buy — or at least not sell — into steep declines. The buy-and-hold approach, after all, is really a buy-and-rebalance approach, and investors adhering to it must rebalance in down market by purchasing stocks.

We are grateful to the clients who have entrusted us with the management of their capital, and we look forward to meeting new ones who seek an alternative approach. Click here to schedule an appointment with us if you are interested in hearing about our approach to asset management and financial planning.

Why Recent Volatility Is a Gift For Investors

Warren Buffett’s teacher, Benjamin Graham, once wrote:

“The investors chief problem – and even his worst enemy – is likely to be himself.”

The market’s recent volatility can give investors an opportunity to reflect on some common psychological pitfalls and not be their own worst enemies.

Investors damage themselves mostly by selling stocks when they get cheap and buying them when they get expensive. Morningstar’s most recent investor returns study shows that investors in diversified stock funds are giving up nearly one percentage point of returns annually due to bad trading. While the numbers don’t tell us what’s causing investors to lag the returns of their funds, it may well be due to certain behavioral problems. Advisors see the behavior constantly in their practices. And advisors aren’t immune from the behavior themselves.

Behavior Gap

Damaging though it can be, it’s understandable why investors sell low and buy high. Nobody likes to see their portfolio declining, so the inclination is to sell when stocks are going down. And nobody likes to see their neighbor making more money than they are, so the inclination is to buy when stocks are going up. The fear of losing money permanently and the fear of missing out on gains (which may really be just greed) are always at play.  Of course, if you’re supposed to adhere to a target allocation, you must sell when stocks go up to maintain your allocation. And you must buy when stocks go down to maintain your allocation. But investors forget that in times of euphoria or panic.

Sometimes being in the right parts of the market can help, whether you’ve emphasized the right sectors or the right parts of the world. But, as this Morningstar article notes, there were few places to hide during the stock market’s recent unpleasantness. And that may be the case next time as well, since all asset classes seem to have risen in tandem after the financial crisis.

That leaves the question of owning more bonds. From February 1st through February 9th the S&P 500 Index dropped around 7%, not including dividends. Over that period, the iShares 10-20 Year Treasury Bond ETF (TLH) lost only around 1% in price – a considerable improvement over stocks. And, of course, cash didn’t lose anything.

An Opportunity To Reassess Risk Tolerance & Allocation

The lesson investors should take from the recent market turbulence is to think about whether it frightened them and how much it frightened them. After all, an investor’s bias should be to buy when the market is going down. That’s not to say the roughly one-week correction we had is all the downside we’ll see, and that buying stocks while it was happening would have guaranteed rock-bottom purchase prices. But an investor should be inclined to buy when markets are falling, not sell. Similarly, the bias should be toward trimming stock from a portfolio during market surges. Use the recent turbulence to take the temperature of your emotions. What were you inclined to do when you saw your portfolio’s value declining?

When investors complete the risk questionnaires that their advisors give them, it’s difficult for them to remember how they felt during the last bear market. Behavioral finance calls the inability to access old feeling the “empathy gap.” As a result, many investors indicate on risk profile questionnaires that they are more risk-tolerant than they really are. Don’t’ squander the gift last week’s recovery gave you to think about how the week before felt. If you wanted desperately to sell, you probably have the wrong allocation.

I talked to an investor during the correction whose portfolio was down around 5%. We surmised he probably had a balanced – roughly half stocks and half bonds – allocation, and that’s normally considered reasonable for his age (early 50s). But he was rather disturbed by this volatility, and we couldn’t help but conclude that his allocation was too aggressive for his personal taste and comfort.

Advisors tell clients that a 5% decline isn’t much. It’s really the price of admission into the stock market, which experiences 10% drops with great regularity. That may be true, but many investors don’t realize what it will feel like when they see their account decline. Many investors indicate that they can handle a 20% decline in their portfolios on risk questionnaires. But a 5% decline, after all, will reduce a $500,000 portfolio by $25,000. That’s usually not catastrophic, but it’s unnerving for someone who hasn’t experienced it before. And it can push them to sell stocks at lower prices. A full 20% decline will reduce a $500,000 portfolio by $100,000, and the older you are, the more unnerving that can be.

A balanced portfolio (50%-60% in stocks) should a reasonable one for many people 15 years from retirement into early retirement, but many investors are unaccustomed to its volatility, and many advisors are unaware of how unaccustomed their clients are to its volatility. Investors should use this opportunity to decide if they need to reduce their stock exposure, and advisors need to reassess how well they’re preparing clients for inevitable downturns. Advisors don’t like to be negative. They think, with some justice, that negativity will make it harder to attract and retain clients. But they must focus on the downside and educate clients better. It’s arguably their fiduciary duty, and it will make for better client experiences in the long run.

Think In Dollar Terms, Not Percentage Terms

Investors should do at least one more thing in response to the recent volatility. Think in dollar terms, not percentage terms. Most investors don’t know what a 5%, 10%, or 20% decline really means for their portfolios. They’re not used to thinking in percentage terms. Go through the exercise of thinking about what each of these declines means in dollar terms for your portfolio. It will help you understand how much risk you’re taking and whether you can tolerate it. We’ve had two 50% top-to-bottom stock market drawdowns within the past 20 years. Valuations are stretched now, and there’s nothing to say we can’t have another one – though, as always, there’s no certainty that we will have one. The time to prepare is now – after the gift the market just gave you in dropping a lot, but then recovering a lot.