How to Ruin a Good Thing

Buffett’s remarks absolutely nail the benefits of our global free-market system which has delivered healthy returns over time. The problem is that most people deprive themselves of those returns by trying to escape short-term volatility. They trade, they guess and they hang on to every little bit of information, making predictions about future events based on news that is already factored into stock prices.

These active investors get bogged down in day-to-day stories such as the potential impact of swine flu, North Korea, the outcome of GM, or whether Obama proved his salt in his first 100 days. They miss the forest for the trees, losing perspective of the historically positive effects of capitalism over time.   

The overall impact of time on an investment in global capitalism has been very positive. But, the positive returns have not been consistent in the short-term. Over time, it is the businesses of the world that adapt to the evolving marketplace — profiting, adjusting or perishing. It is these businesses that pay us a risk premium for investing in them. This is why investors can expect to earn a return.

This return on an investment in global capitalism is available to all market participants, but so few actually get them. Active investors ruin a good thing and deprive themselves of the long-term returns of capitalism that are theirs for the taking.

Each year, Dalbar reveals the returns of the average equity investor, comparing those returns to the S&P 500 Index. The chart below shows the results of their Quantitative Analysis of Investor Behavior study for the 20-year time period from January 1989 through December 2008.

As the chart shows, the average equity investor in the study earned just 1.87% annualized return over the 20-year timeframe — significantly underperforming even the risk-free rate of return offered by a one-year T-Note! When inflation for the 20 years is considered, the returns of the average equity investor turned negative, with a $100,000 investment in 1989 worth just $82,288 net of inflation.

In contrast, an investment in the S&P 500 index would have earned an 8.42% annualized return for the 20-year period with a $100,000 having grown to $296,141 net of inflation. Even better, a globally diversified all-equity index portfolio such as IFA’s Index Portfolio 100 would have earned a 9.21% annualized return with $100,000 growing to $343,597 after inflation was considered. All investors had to do was buy, hold, and rebalance a risk-appropriate, low cost portfolio of index funds and get on with the joys of living.

Click to Enlarge the Chart

This significant study and many more just like it reveal the peril in store for those who attempt to circumvent market downturns and capitalize on market upturns. Commissioned stock brokers and active managers would have investors believe that these short-term movements have negative impact on long-term expected returns, when in reality it is the trading activities promoted by their self-serving recommendations that destroy investor returns. Any advisor who gets paid a commission or salary based on trading would starve if they told you “don’t just do something, sit there,” despite the fact that it is in following their recommendations that most investors ruin a very good thing.