| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
People cannot afford to make too many investment mistakesInvestment Return Shortfalls There was a time when a fool and his money were soon parted, but now it happens to everybody. Adlai Stevenson BUILDING AND MAINTAINING WEALTH can be divided into two tasks. The first task, covered in Chapter 1, is saving money, which includes dutifully depositing small amounts into savings each month while working full-time. The second task is investing those savings properly, from the day your first dollar goes into a savings account until the last day you remain among the living, and in some cases even into the hereafter. As your wealth grows, the rate of return on that money becomes increasingly important. Given the declining level of retirement income from guaranteed employer pensions and Social Security and the lower returns expected from the financial markets in the future, people cannot afford to make too many investment mistakes. Retirement accounts need to be managed according to a well-tailored, low-cost investment plan that is designed using modern financial planning tools. If managed correctly, a nest egg Investment Return Shortfalls can grow to the point where it will meet retirement income needs without excessive risk and you will not fear outliving your money. Unfortunately, the facts show that we do not do a very good job of saving and investing. Several studies on the rate of return in selfdirected retirement accounts show that an overwhelming majority of people earn far less than they should be earning. How low are the returns of individual investors? The Nebraska Retirement System 401(k) plan is one of the oldest 401(k) type plans in existence and has performance data going back several decades. Figure 2-1 illustrates the average performance for workers who participated in the plan from 1970 to 1999. The bar on the right is the annual return that the average worker earned on personal savings in the self-managed portion of the 401(k) plan. The middle bar represents the annual return of professional money managers hired by the Nebraska Retirement System to manage the states defined benefit plan. The bar on the left is the annual return of a static mix of 45% in the S&P 500 stock index, 45% in a five-year Treasury note, and 10% in a Treasury bills. The mix would be considered a conservative, balanced account. As a group, the professional money managers who control a portion of the states pension assets matched the performance of the static mix of 45% stocks, 45% bonds, and 10% cash. Looking at the bar to the right in Figure 2-1, we see the average worker earned significantly less than the managers or the static mix. Why? Were the employees misinformed? Did they have poor mutual funds to invest in? The fact is that workers were given a substantial amount of written information covering the fine investment choices in their plan as well as diversification guidelines. They were also allowed to take paid time off during the workweek to attend free investment seminars on investment principles. Nonetheless, the fliers, booklets, and seminars did not help the typical employee. In 2001, the National Center for Policy Analysis published a study of 401(k)s by benefits attorney Brooks Hamilton and financial columnist Scott Burns, Reinventing Retirement Income in America. The study examined the investment returns of hundreds of 401(k) retirement plans and thousands of accounts for the years 1990 through 1995. The authors concluded emphatically that workers underachieved the markets performance in their 401(k) accounts. This was especially true of lower-paid employees. Hamilton and Burns constructed a second database of 500,000 investment returns from 401 (k) participants for the year 1998. That year the average 401(k) account returned 8%, whereas a static mix of 45% stocks, 45% bonds, and 10% in T-bills returned 18%. Further analysis of the Hamilton and Burns database found that a high percentage of low-wage earners held almost two-thirds of their savings in low-yielding fixed-income type investments such as money market funds. One explanation for the concentration in money funds was the default selection in many 401k documents. If an employee does not choose to invest in any other option when signing up for a 401(k) type plan, then 100% of his or her savings default to a low-yielding money market fund. For many individuals, the process of selecting investments for a retirement account is too confusing or intimidating. Those employees tend to place their savings in the safest, yet lowest-yielding investments and miss out on the superior long-term gains from stocks and bonds. The Nebraska Retirement System realized there was a problem and decided to do something about it. With this new information, Nebraska decided to move in an opposite direction from where most other employers were going. Instead of requiring employees to manage their own accounts, the state now offers a new option to current employees. The participants can select a pooled investment account that is professionally managed by state-selected investment firms and be guaranteed a minimum benefit at retirement by the state. All new hires were placed in the new plan starting in 2002. The pendulum is swinging back to a guaranteed benefit plan in Nebraska. That is a good sign, but the only one so far. Most other government and corporate employers continue to push in the direction of self-management, which implies lower retirement benefits for employees. As of July 1, 2002, Florida started allowing state employees to move their funds out of the state-guaranteed defined benefit plan and into a new self-directed plan. This means employees who move are giving up a guaranteed paycheck at retirement for the hope of growing a larger benefit for themselves by investing their own account. The state will continue to fund both plans, but the retirement income of those employees who switch to the self-directed option will no longer be set according to a standard formula. It will depend on the employees investment skills. If you are a Florida state employee, I would not recommend switching to the self-directed plan unless you are very confident about your investment knowledgeand then I would think twice. The country is torn by the question of who should manage retirement plans. Some employees want complete control of their investments and others do not. The challenge is to give control to those who want it and protect those who do not want it, while decreasing administrative costs and the legal liability of the employer. Currently, over 50% of households in America are covered under some type of employee self-managed and self-funded retirement plan where they work, such as a 401(k) plan, while less than 40% of households are still under an employer-funded and employer-managed defined benefit plan, which provides guaranteed income at retirement. Among employers that still fund defined pension benefits are federal, state, and local governments, as well as large corporations that are heavily unionized. However, each year the number of workers responsible for managing their own retirement savings is going up and the number of employers offering monthly pension checks is going down. It is not likely that employers will follow Nebraskas lead and shift back to guaranteed retirement benefits. That would be too costly and carry too much regulatory burden. Evaluating Poor Performance There is every indication that the aggregate return of self-managed retirement accounts will continue to be significantly lower than the aggregate return of employer-managed plans. If you have an understanding of why the performance of individually managed accounts has been below average in the past, it will help you correct problems in your own retirement savings for the future. Basically, there are five main reasons for the poor performance in individual retirement accounts. Four of them apply to all individuals and one of them applies only to employees in companies that have publicly traded stock: 1. A large number of people choose low-yielding investments for a significant portion of their plan, such as money market funds and guaranteed fixed-rate annuities. These investments are simple to understand, and do not require knowledge of the stock market, bond market, or diversification techniques. These investors could earn a higher return on their savings by taking a small amount of risk, but choose not to. 2. On the other end of the spectrum are investors who trade their retirement accounts frequently. These people tend to follow the financial markets closely and attempt to get into or out of investments at the right time. Generally, individuals who trade their accounts frequently receive the lowest returns. This was the conclusion of several studies conducted by University of California professors Brad Barber and Terrance Odean. Investment Return Shortfalls 3. There are a lot of people who fall in the middle. They do not know what to do, but know they must do something in their account. These investors tend to be casual observers of the markets, but not overly interested in the day-to-day activity. They may listen occasionally to the media chatter about the markets and are aware of the performance of a few mutual funds they own, but they do not react to every market move. When they make a move, the change typically needs to be validated by friends, relatives, coworkers, or media. Basically, most investors follow trends. They tend to do what others do and buy what others buy. This investment strategy nearly always results in performance below a basic buy-and-hold, static stock-and-bond mix. 4. The fourth category of poor performance applies only to people who work for companies that are public and have stock that trades on the stock market. Some employees of these companies put their faith, trust, and money behind their employers by investing a large portion of their retirement savings in their own companies stocks. Strangely, surveys indicate that employees believe that there is less risk in owning company stock than a diversified portfolio of several stocks. In reality, there is significantly more risk to owning just one stock, even if that is the company you work for. This strategy swings both ways. A heavy concentration of company stock worked well for the early employees of Microsoft, but it did not work for employees of Enron or WorldCom. 5. The final reason for poor performance does not have anything to do with investment behavior; it is all about costs. Investment fees and expenses reduce the performance of every investment account, even large institutional pension plans. However, individuals pay a lot more per dollar invested than large institutions. Depending on the investments owned, a person can give up 2% or more each year to pay for management fees, commissions, and administrative costs. Expenses are a major reason why selfmanaged retirement accounts do not perform anywhere close to the markets they invest in, although all the risk is still there. Investment advice found in the mass media and sale ads paid for by Wall Street firms make investing sound so easy. You are told to buy this and sell that, which will put you on the road to riches. The problem is, next month it is a different set of investments, and the month after that yet another. If making money were as easy as following popular advice, why did so many people lose so much money in their retirement accounts between 2000 and 2002? Here is an unfortunate but true story of a 70-year-old barber in my hometown, whom I will call Ed. In early 1998, Ed had accumulated a $700,000 nest egg by diligently saving for almost 50 years. He was hoping to get his account up to $1 million over the next five years and then retire. Ed was a conservative investor. Most of his money was in bank certificates of deposit, earning a competitive yield, and a small portion was in a diversified stock mutual fund, which was doing quite well. It was a simple portfolio, yet a practical investment approach for his level of expertise. Every day during the growth stock boom, Eds customers would talk about investing in technology stocks, especially the red-hot Internet sector. Although his intuition told him to stay away from picking stocks, Ed wondered if he should give it a try. If a few of those stocks worked out, then he could retire earlier. So, during 1999, Ed bought his first technology stock on the advice of a stockbroker customer. After some surprising success, along with a lot of backslapping from his new best friend the stockbroker, Ed decided that the CD rates he was getting at the bank were no longer attractive and he started rolling out of CDs and putting more money into tech stocks. Over the next six months, Ed traded all kinds of stocks that were recommended to him. He learned all the stock-trading buzzwords and even installed a computer in the office so that he could check quotes and trade stocks during breaks. At night, Ed started analyzing price charts, looking for ones that were breaking out. He also discovered Internet chat rooms and monitored the conversations to ensure his stocks were well represented. By early 2000, Ed was a day-trading maniac. He traded in the morning, between customers, during breaks, and at night and he studied stocks all weekend long. Ed believed his stock selection method was refined, that there was little risk of loss. About the time technology stocks were peaking, Ed kept me in his barber chair for nearly an hour explaining in great detail how his system worked and why. He even mentioned that I should consider using his method to invest my clients money and he generously offered to supply me with his recent picks. As you may have guessed, Ed arrived a little too late to the party. He almost made it to $1 million before losing over 60% of his retirement savings during the next 30 months. After that, Ed was in no position to retire early. In fact, he was in no position to retire at all. Despite his near ruin, Ed still feels he was fully justified in his actions. All of the good stock picks were mine, and all of the lousy ones were my brokers! he claimed. My mistake was not firing that broker a long time ago. What was Eds real mistake? The real mistake was that Ed did not follow through with the sensible investment plan that he started years ago. If Ed had simply continued to buy bank CDs and put money in the stock fund, he would be hanging up his hair dryer today. Instead, he no longer plans to retire. He cannot afford to. Behavioral Finance When you get down to the basics, we are our own worst enemy. We are prone to have warped perceptions of our ability that cause us to act irrationally. Investors look at stock charts and see trends that do not exist and they turn wishful thinking fiction into investment facts. Behavioral finance is the study of how psychology affects investment decision-making, which ultimately affects portfolio performance. This field of study is not new, but it has taken on new meaning over the last 10 years. Richard H. Thaler, a professor of behavioral science and economics at the University of Chicago, has been studying behavioral finance for over 20 years. His research has shed light on behaviors covering everything from buying lottery tickets to investing retirement money in speculative Internet ventures. Thaler believes most investors suffer from overconfidence. The average person thinks he or she is above average in many ways. Numerous surveys have shown that people tend to believe they are better-than-average drivers, better-than-average-looking, betterthan-average managers, and are less likely to lose their jobs than their coworkers. In their article, Aspects of Investor Psychology (Journal of Portfolio Management, Summer 1998), Daniel Kahneman, a psychology professor at Princeton University, and Mark W. Riepe, a senior vice president and research chief at Charles Schwab & Co., wrote: The combination of overconfidence and optimism is a potent brew, which causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. Overconfidence is a key factor in peoples tendency to concentrate their investment holdings in one particular asset class, market sector, or company, according to Thaler. Thats certainly the case when it comes to company stock, he said. People think they have some sort of inside information, and everyone thinks the company they work for is above-average. That second point cant possibly be the case, and theres no evidence whatsoever to support the first point.2 A grand illustration of overconfidence occurred between 1998 and 2001, when technology stocks went from boom to bust. While they were booming, everyone was an expert, but when they collapsed, no one would admit to being a bad stock picker, especially the analysts on Wall Street. Most individual investors I talk with blame somebody else for their loss: a broker, a relative, a coworker, or a TV stock analyst. Ironically, these same investors now say they knew the market was high and that the bubble had to burst. Isnt it amazing how our minds distort the truth to protect our egos? Another area Thaler studied was false pattern recognition. Human beings like patterns. Many people believe that randomness is the exception rather than the rule. Surveys have shown that in a coin-toss experiment many people believe that a sequence of headstails-heads-tails-heads is more likely to occur than all heads, all tails, or some other order. In fact, the probability of any of these results is the same. You can see false pattern recognition behavior all over Las Vegas. Some people who play roulette and baccarat keep meticulous notes of the numbers that come up during the game under the illusion that tracking past random numbers gives some indication of future random numbers. I am amazed to watch these people because when they win, they believe it is skill, but when they lose it is bad luck. Our fondness for patterns sometimes leads us to assume that investments that have done well in the past will continue to do well in the future and those that have performed poorly will continue to do poorly. Interestingly, people tend to overreact when they think a trend has developed. Once were convinced that a trend is there, we act as though it will continue indefinitely. In addition to Thalers findings, behavioral researchers have learned that children who inherit stocks and stock mutual funds from their parents are less likely to sell those securities than other investments. The reason they give for not selling is that if Dad or Mom bought the securities, then they must be good. I have seen heirs lose millions of dollars holding stocks that they should have diversified away a long time ago. All of the behavioral research studies can be cumulated into one observation. Investors have only a vague idea of how well they are managing their investments. Most people believe they are doing much better than is actually the case. One study measured the difference between how investors perceived their returns and the actual returns. The research found that that the average difference between perceived returns and actual returns was about 3% per year.3 In addition, that gap grew larger as the time frame expanded. The Beardstown Ladies Investment Club of Beardstown, Illinois is a classic example of how wide the gap can grow between perceived investment results and actual results. The women in this legendary investment club rose to prominence in the mid-1990s after they proclaimed fantastic returns for their club investment account. For 10 years ending 1993, the club reported a compounded return of 23.4%, versus a return of 14.9% in the S&P 500. How did they do it? By purchasing stocks like Coke, McDonalds, and other household names. Their complete methodology was published in 1996 in a best-selling book, Beardstown Ladies Common-Sense Investment Guide, which sold over 800,000 copies. The women went on to write four more booksbefore an error was discovered in their investment calculation. In late 1997, the managing editor of Chicago magazine noticed something peculiar about the investment results published in the Common-Sense Investment Guide and concluded that a gross error had been made. The mistake was so large that the accounting firm of Price Waterhouse was called in to clear the air. In the final analysis, the clubs worst fears were realized: their return was actually only 9.1% over the period, far below 23.4%, and well below the S&P 500. An embarrassed club treasurer blamed the error on her misunderstanding of the computer program. What is ironic about the Beardstown Ladies is they were putting themselves out as investment experts, yet no one in the club was expert enough to notice that their reported portfolio returns were exceedingly high in relation to the return of the stocks they purchased. I do not believe these women were trying to deceive anyone. I truly believe they thought they were beating the market. If you enjoyed reading this section on behavioral finance, I highly recommend reading Larry Swedroes book, Rational Investing in Irrational Times (New York: St. Martins Press, 2002). It highlights 52 investment common mistakes most people make, referencing all the published literature on the subject. The easiest thing of all is to deceive ones self; for what a man wishes, he generally believes to be true. Chapter Summary There are two sides to a personal retirement savings program. One side is a dedicated savings program and the other involves investing those savings properly. There currently is a shortfall on both sides. The below-average performance of self-directed accounts can be attributed to two factors: bad behavior by investors and high investment expenses. Investors behave badly in a number of ways. Some people simply choose to keep their retirement savings in a low-yield money market fund. Others play the markets excessively, which inevitably leads to below-average returns. A third group meanders around, not knowing what to do. Finally, there is a group of corporate employees who load up their retirement accounts with their company stock, believing it is safer than a diversified portfolio of stocks. In addition to human behavior, a second detriment to performance is high investment costs. This includes expenses relating to trading commissions, management fees, and the internal costs of investment products like mutual funds and variable annuities. On average, investors spend much more than they should to invest their retirement savings. There is a vast difference between perception and reality in the financial markets. We rank our investment ability at a much higher level than it is. Evidence of this fact is found in our belief that our past investment returns are much higher than they really are. We selectively remember the good investments while discarding the bad ones. We tend to overestimate future returns and underestimate the risks. Awareness of common investment errors outlined in this chapter is a big step toward correcting them. Key Points 1. As a nation, we are not earning a fair rate of return on self-directed retirement accounts. . Lack of investment knowledge and misperceptions about our investment skills are the leading causes of poor results. 3. High fees and expenses contribute to below-average returns. 4. Awareness of these common mistakes is a big step toward correcting them. 1. Brad M. Barber and Terrance Odean, Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors, Journal of Finance, Vol. 55, No. 2, April 2000, pp. 773-806. 2. The Vanguard Group, For Investment Success, Be on Your Best Behavior, In The Vanguard, Spring 2002. 3. William. N. Goetzmann and Nadav Peles, Cognitive Dissonance and Mutual Fund Investors, Journal of Financial Research, 20:2, Summer 1997, pp. 145-158. One group of investors consisted of people who were members of an investment club and the other group consisted of people who were less informed participants in a small retirement plan. The informed group had no better record of guessing their performance than the less informed group. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |