Why Active Investors Fail

Why Active Investors Fail

Why Active Investors Fail

Active Investors Fail to Match Risk Capacity with Risk Exposure

Risk is the source of investment returns, yet investors want to avoid it. It serves investors well to learn about and embrace risk in accordance to their capacity level. Risk Capacity defines the risk level that is appropriate for a particular investor. Many investors invest in portfolios that are mismatched to their Risk Capacity. A thorough analysis, such as the one in Step 10: Risk Capacity, looks at an investor’s investment time horizon, net worth, income, investment knowledge, and attitude towards risk. With this analysis, an investor can then review investment choices and make a selection that matches personal Risk Capacity.

An investment policy or portfolio is a statement of the Risk Capacity assessment and the resulting risk exposure, in the form of an asset allocation of indexes.

Most investors do not get around to fully assessing their Risk Capacity and find themselves without an investment policy for their short-term and long-term investing. Without this policy, they are easily persuaded to change their course. They lose out on the long-term returns that would result from subjecting their capital to risk.

Active Investors Pay a High Cost of Turnover

High turnover can create high capital gains in a mutual fund or a portfolio of individual stocks. In taxable accounts this can create a strong headwind to beating an index. According to Morningstar as of February 2014, the average large cap mutual fund turns over 62% of its stock each year. This high percentage can force the distribution of capital gains by the fund, which become tax liabilities for the fund’s shareholders. Active investors tend to incur far greater federal and state taxes, especially when the capital gains are short-term and are taxed at the investor's marginal rate. On the other hand, index fund investors who simply buy and hold will normally have lower capital gains. When they do, they are usually long-term gains that are taxed at the capital gains rate. Furthermore, tax managed index funds can harvest losses to offset gains. Since they are passively managed, they will normally have lower turnover rates, thus reducing federal and state taxes for their shareholders. In addition to taxes, high turnover can inflict a cost on shareholders that is in addition to the fund's annual expense ratio. In an article1 in the Financial Analysts Journal, John Bogle estimates this cost at 0.5% per year. 

Active Investors Suffer Emotional Stress

Investment returns are far more dependent on investor behavior than the performance of the investment. Investors generally make bad decisions under the pressure and stress of trying to outperform a market. These shortfalls are directly attributed to investors overreacting to constantly changing conditions in financial markets, resulting in brief holding periods for mutual funds. The tendency of investors to bail out of stock funds during market downturns and buy back in too late when the markets recover obviously harms performance.

In fact, trading patterns analyzed by the Dalbar study2 showed that most investors invariably buy high and sell low. The more an investor buys and sells mutual funds, the lower the expected return. All these findings were also true of bond fund investors. According to the study, a buy-and-hold strategy outperformed the average investor by more than three to one after ten years.

When the stock market performs well, as it did for most of the 1980's and '90's, investors are more prone to believing they can beat a market. When they get lucky and make a profitable investment call more than once, they are lured into thinking they are successful market forecasters. Unfortunately, this false sense of confidence leads them to the poorhouse.

The media continues to foster and encourage the high emotions of active investing. Many ads lead investors to believe they can beat a market through stock picking and time picking. In a September 1999 advertisement from Ameritrade (Online Broker), an image of a scowling young woman was displayed. Her quote read as follows: "I don't want to just beat the market. I want to wrestle its scrawny little body to the ground and make it beg for mercy." It goes on to say, "Ready to take on the market? The sooner you do, the sooner you can show that lily-livered stock market who's boss." Finally, it ends with, "Believe in yourself."

Watch this short interview, where James Altucher, managing director of Forumula Capital, says that day trading is a mistake.

A Startling Study of Investor Knowledge

The lack of investor education has generated a lot of recent interest. Most school systems have not incorporated an educational program for investing. The average investor is unprepared to make decisions about investing hard-earned money. Investors usually receive their education in bits and pieces from advertisements, television, magazines, newspapers, or books. These sources are created by an industry that generates huge margin interest, fees, and commissions from the trading of active investors. Most of the promotion and education provided by the investment industry encourages investors to gamble in the stock market.

Money Magazine and the Vanguard Group conducted a study3 in 2002, which randomly selected 1,000 investors from across the United States, and asked them twenty basic questions on investing. The investors received an average score of forty percent, or an "F" grade! This was actually a slight improvement over the 2000 version of the survey where the average score was thirty-seven percent. Why do investors continue to invest in things they do not understand?

 

1Bogle, John C., 2014. "The Arithmetic of All-In Investment Expenses." Financial Analysts Journal, vol. 70, no. 1 (January/February):13-21.

2Dalbar Inc., "2012 Quantitative Analysis of Investor Behavior," (2012).

3https://personal.vanguard.com/us/InvestmentKnowledge