By Jason Zweig | Dec. 20, 2017 8:55 p.m. ET
Image credit: Pieter Bruegel the Elder, “The Battle About Money” (engraving by Pieter van der Heyden), ca. 1570, Metropolitan Museum of Art
Here, from a decade ago, is a piece on why investors underperform their investments. As I look back on it, I think it suffers from the same logical flaw as most coverage of the so-called behavior gap, or the extent to which investments earn higher returns than the people who own them: Namely, in a bull market, a lump sum invested at the beginning and held to the end will tend to earn a higher return than an account that is funded steadily or sporadically over time. So it is a bit simplistic to say that investors hurt their returns by buying high and selling low; they also hurt their returns by not putting all their money in at the beginning and keeping it all there until the end. The fact that no one does (or could!) invest that way shows that we should probably temper our criticism of the behavior gap as proof that investors are irrational. (In a protracted bear market, the same behavior of funding accounts steadily or sporadically over time is likely to make investors perform better than their investments.) It’s also a reminder that commonly cited industry-funded “studies” claiming that investors underperform their investments by huge margins over the long term are flawed.
How to Lose $9 Trillion in a Bull Market
The day-to-day fluctuations of the stock market are hard to fathom, but fortunately they mean very little in the long run.
There is, however, a bigger market mystery well worth pondering: In 1982 the total value of the U.S. stock market, as measured by the Wilshire 5000 index, was $1.2 trillion.
The index has since returned an average annual rate of 13.3 percent — enough to turn that $1.2 trillion into $28.2 trillion. Yet the value of Wilshire stocks, as of Sept. 30, was $18.7 trillion, meaning investors earned far less than 13.3 percent a year.
Did $9.5 trillion disappear? And how can investors earn less than their investments?
An inconvenient truth
An accounting professor at the University of Michigan named Ilia Dichev has cracked the case, and his findings, published recently in the prestigious American Economic Review, have huge implications for how you should invest.
I’ve written before about the gap between the returns reported by mutual funds and the money earned by their investors. Reported returns almost always look better than investor returns because people pile in after a fund gets hot and then sell or freeze after it’s gone cold.
What Dichev’s research shows is that the same thing holds true for the stock market as a whole.
By looking at how much money was flowing into publicly traded companies through initial and secondary stock sales and how much was flowing out via dividends, buybacks and buyouts, Dichev was able to measure the return on the typical invested dollar.
Learning from history
So what about that $9.5 trillion? “The money did not disappear,” says Dichev. “It was never there in the first place.” In other words, reported long-term returns aren’t historical, they’re hypothetical.
The U.S. stock market was never worth $28 trillion. That 13.3 percent “average” return was only for a strict buy-and-hold investor, a description that hardly applies to the big institutional players that move the stock market.
Consider that between 1973 and 2002, Nasdaq stocks gained an annual average of 9.6 percent. But that assumes money was invested on Jan. 2, 1973 and stayed put until Dec. 31, 2002 (with no taxes paid on the gains).
In reality, because investors pumped $1.1 trillion into Nasdaq stock offerings between 1998 and 2000 — just before the worst crash in modern history — the typical dollar invested in the Nasdaq earned only 4.3 percent a year, less than half the historical return.
So what can you learn from Dichev’s research?
First, the more an investment jumps around in price, the more likely you are to underperform its average return. Big swings will give you more opportunities to buy high and sell low.
Technology stocks in the 1990s, and energy and real estate stocks in this decade, earned much higher returns than the people who invested in them. The same thing will happen with today’s hotties, like emerging-markets funds.
You aren’t mistaken to own them, but you’re wrong to overdose on them in pursuit of high reported returns that very few people ever got to enjoy.
Second, for you to match the market’s historical return, three things have to happen.
For starters, history has to repeat itself, with stocks continuing to produce high returns well into the future. (That, by the way, is no sure thing.)
Next you must invest in the entire stock market at rock-bottom cost, preferably through a total stock market index fund.
Then you must refrain from trading along the way.
If you take any other course of action, your results will differ from those of the market — most likely for the worse.
Based on decades of data from 19 countries, Dichev thinks that the average investor incurs a “timing penalty” of 1.5 percentage points a year by buying high and selling low. Impatience will cost you dearly.
“How to Lose $9 Trillion in a Bull Market,” Money magazine, December 2007
Jason Zweig, Your Money and Your Brain, especially Chapter Four, “Prediction”
Jason Zweig, The Devil’s Financial Dictionary
Benjamin Graham, The Intelligent Investor, especially Chapter Eight, “The Investor and Stock Market Fluctuations”
Ilia D. Dichev, “What Are Stock Investors’ Actual Historical Returns? Evidence from Dollar-Weighted Returns” (American Economic Review, 2007)
Ilia D. Dichev and Gwen Yu, “Higher Risk, Lower Returns: What Hedge Fund Investors Really Earn” (Journal of Financial Economics, 2011)
Geoffrey C. Friesen and Travis R.A. Sapp, “Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability” (Journal of Banking & Finance, 2007)
Oded Braverman et al., “The (Bad?) Timing of Mutual Fund Investors” (working paper, 2005)
Jason Hsu et al., “Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies” (Journal of Portfolio Management, 2016)
John Chalmers et al., “The Wisdom of Crowds: Mutual Fund Investors’ Aggregate Asset Allocation Decisions” (Journal of Banking & Finance, 2013)
Russel Kinnel, “Mind the Gap: Global Investor Returns Show the costs of Bad Timing Around the World” (Morningstar, 2017)
But, for a dissenting view, see: Aneel Keswani and David Stolin, “Dollar-Weighted Returns to Stock Investors: A New Look at the Evidence” (Finance Research Letters, 2008)
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