Academically my background is in financial and risk management. During university I studied the usual stuff, economics, corporate finance, and probably the subject that most interested me was statistics. We learned about portfolio construction, risk, diversification, correlations, R-squared, standard deviation, gamma, delta, and the list goes on. We spent a lot of time optimising portfolios and assessing possible risks that may impact the portfolio’s performance.
One of the biggest things I’ve learnt since coming out of the academic world and into world of people and money, is that you cannot diversify away from human behaviour. The cognitive biases that are inherent in all human beings are the biggest risk to our portfolios. It’s not the Fed raising rates too quickly, it’s not deflation, inflation, or hyper inflation, it’s not property prices crashing, it’s not trade wars, it’s our cognitive biases and poor understanding of how markets work that destroy our wealth.
It was 10 years ago the GFC tore through world markets and was on the verge of paralysing our economy for good. But it didn’t. And you would have thought as investors, we would have learned a lesson or two from this experience. Nope – we have gained no new wisdom, nor have we gained any further self awareness.
The lessons that can be taken from the GFC will remain in history books forever, and you will hear old folk tale from investors decades from today.
At a financial markets conference in New York, Cliff Asness did precisely that. “We are not market-timing”, said the large endowment fund, “but we will probably return to U.S. equities in the spring.” Rarely at a loss for words, Asness was left sputtering and speechless.
At the same conference Bill Miller told this story: He presented the idea of buying junk bonds in December 2009 to a large firm’s investment committee. At the time, the bonds were trading at 22 cents on the dollar, but the idea was rejected by the committee as too risky. Five years later the fund bought these same bonds at a much higher price and much greater risk. (Miller was not involved in that transaction).
These errors led Asness to observe, “You can have a committee of 10 geniuses that proves collectively to be a moron.”
As can be seen from the below chart (click for larger image), financial markets have rewarded long-term investors. Investors who have a game plan in place, who have taken the long view, and who have remained disciplined and patient.
I get it, it’s super hard. And this is precisely why financial research and literature is littered with evidence that human behaviour is the biggest detractor of performance, also known as the ‘behaviour gap’.
The below research, conducted by Dalbar, clearly illustrates how difficult it is to remain focused on the long game. The average investor over all time frames has underperformed the market. For example, over the last 20 years, the average equity fund investor returned 4.67% pa, whereas the S&P500 returned 8.19% pa. The average investor underperformed the market by 3.52% pa. The investor simply had to do nothing and their portfolio would have returned 8.19% pa for 20 years. Yet they chose not to. They succumbed to their human biases and did something, which detracted from their performance.
Don’t do something, just stand there.
– Jack Bogle
They could have spent that time doing things they loved; built a business, spent time with their family, traveled, rebuilt an old muscle car. But they chose not to. They chose to “manage” their own money.
Here are the specific causes for underperformance, with investor behaviour making up a staggering 42% of the loss (1.50% pa of 3.52% pa).
As the scars of the last financial crisis heal, we plant the seeds for the next crisis that will again decimate financial markets. And next time it won’t be different, it will only seem that way due to our inability to learn from our prior experiences, a failure to understand our own limitations, and poor risk management. Blame no-one but yourself.
Source: Dalbar, Vanguard, Bloomberg: The Next Financial Crisis is Staring Us in the Face