Chapter 8
Why most people lose money in the
market
In the preceding chapter, I presented to you a very rosy view of the stock market and its wealth-building potential. Everything I wrote is true. But, this too is true:
Most people lose money in the stock market.
Here’s why:
1. We think we can time the market.
While stepping out when it is high and back in when it is low sounds enormously appealing, it is almost impossible to do. The reality is that we usually buy high and sell low, panicking when times are tough and buying when the market is soaring.
This applies to all of us. It is the way humans are hard-wired. Over the past twenty-odd years an array of academic papers have appeared investigating the psychology of investors. The results aren’t pretty. Seems we are psychologically unsuited to prosper in a volatile market. The details of this research are beyond the scope of this book. But what is important is that it takes an act of will, awareness and effort to understand, accept and then change this destructive behavior.
Here’s a sobering fact: The vast majority of investors in mutual funds actually manage to get worse returns from their funds than the funds themselves generate and report. Let that little nugget sink in for a moment.
How can this be? Our psychology is such that we can’t help trying to “time” the market. We tend to jump in and out, almost always at the wrong times.
2. We believe we can pick individual stocks.
You can’t pick winning stocks. Don’t feel bad. I can’t either. Nor can the overwhelming majority of professionals in the business. The fact that this ability is so rare is the key reason why the very few who apparently can are so famous.
Oh, sure. Occasionally we can and, oh my, what a heady feeling it is when it works. It is incredibly seductive. Picking a stock that soars is an intense and addictive high. The media is filled with “winning” strategies that feed on this delusion.
I am not immune from the attraction. Back in 2011 I thought I had spotted a trend and as it happened made 19% in four months on the five stocks I chose. (Sigh. I still have this addiction.) That’s almost 60% annualized, while the market was flat for the year. That’s spectacular, if I do say so myself. It is also impossible to do year after year. It’s a great rush, but a very poor foundation upon which to try and build wealth.
Even slightly beating the index year after year is incredibly difficult.
Only a handful of investors have been able to modestly beat it over time.
Doing so makes them superstars. That’s why Warren Buffett, Michael Price and Peter Lynch are household names. That’s why I don’t let my occasional win go to my head. That’s why I let index funds do the heavy lifting in my portfolio.
3. We believe we can pick winning mutual fund
managers.
Actively Managed Stock Mutual Funds (funds run by professional managers, as opposed to Index Funds) are a huge and highly profitable business. Profitable for the companies that run them. For their investors, not so much.
So profitable that there are actually more mutual funds out there than 5 stocks. According to the U.S. News and World Report,as of 2013 there were about 4,600 equity (stock) mutual funds operating in the U.S. Recall there are only about 3,700 publicly traded stocks in the U.S. You read that correctly. Yeah, I’m amazed too.
The article goes on to say about 7% of funds fail each year. At that rate, more than half (2,374 of those 4,600) will fold during the next decade.
With so much money at stake, investment companies are forever launching new funds while burying the ones that flounder. The financial media is filled with stories of winning managers and funds, and lavishly profitable advertising from them. Past records are analyzed. Managers are interviewed. Companies like Morningstar are built around researching and ranking funds.
The fact is, few fund managers will beat the index over time. In 2013, Vanguard posted the results of their research on this. Starting in 1998 they looked at all of the 1,540 actively managed equity funds that existed at the time. Over the next 15 years only 55% of these funds survived and only 18% managed to both survive and outperform the index.
82% failed to outperform the unmanaged index. But 100% of them charged their clients high fees to try.
While we can clearly see those that succeeded now, there is no predicting which funds will be in that rarefied 18% going forward. Every fund prospectus carries this phrase: “Past results are not a guarantee of future performance.” It is the most ignored sentence in the whole document.
It is also the most accurate.
Other academic studies suggest that when looking at longer time periods, even an outperformance rate of 18% is wildly optimistic. In the February 2010 issue of The Journal of Finance, Professors Laurant Barras, Olivier Scaillet and Russ Wermers presented their study of 2,076 actively managed U.S. stock funds over the 30 years from 1976 to 2006. Their conclusion? Only 0.6% showed any skill at besting the index or, as the researchers put it, the result was “...statistically indistinguishable from zero.”
They are not alone. Brad Barber of UC Davis and Terrance Odean of UC Berkeley found that only about 1% of active traders outperform the market and that the more frequently they trade, the worse they do.
With this terrible track record, you might be wondering how is it that so many fund companies run ads that claim most, if not all, of their funds have outperformed the market. With so much money at stake it is not surprising that they have their tricks. One is simply to selectively choose a time frame for measurement that happens to work in their favor. Another just takes advantage of all those dead and dying funds.
Mutual fund companies launch new funds all the time. Random chance is enough to predict a few will do well, at least for a while. Those that don’t are quietly closed and the assets folded into something doing better. The bad fund disappears and the company can continue to claim its funds are all stars. Cute.
There’s lots of money to be made with actively managed funds. Just not by the investors.
4. We focus on the foam.
Imagine you’ve been reading this book on a nice warm summer’s afternoon.
Richly deserving of a reward, you crack open a bottle of your favorite brew and pour it into a nice chilled glass.
If you’ve done this before you know that if you carefully pour it down the side you’ll wind up with a glass filled mostly with beer and a small foam head. Pour it fast and down the center and you can easily have a glass with a little beer filled mostly with foam.
Imagine now someone else has poured it for you, out of sight, and into a dark mug you can’t see through. You have no way of knowing how much is beer and how much is foam. That’s the stock market.
See, the stock market is really two related but very different things:
It is the beer: The actual operating businesses of which we can own a part.
It is the foam: The traded pieces of paper that furiously rise and fall in price from moment-to-moment. This is the market of CNBC. This is the market of the daily stock market report. This is the market people are talking about when they liken Wall Street to Las Vegas. This is the market of the daily, weekly, monthly and yearly volatility that drives the average investor out the window and onto the ledge. This is the market that, if you are smart and want to build wealth over time, you will absolutely ignore.
When you look at the daily price of a given stock, it is very hard to know how much is foam. This is why a company can plummet in value one day, and soar the next. This is why CNBC routinely features experts, each impressively credentialed, confidently predicting where the market is going next—while consistently contradicting each other. It is all those traders competing to guess how much beer and how much foam is actually in the glass at any particular moment.
While this makes for great drama and television, for our purposes it is only the beer that matters. It is the beer that is the real operating money making underlying businesses, beneath all that foam and froth, that over time drives the market ever higher.
Understand too, that what the media wants from these commentators is drama. Nobody is going to sit glued to their TV while some rational person talks about long-term investing. But get somebody to promise the Dow is going to 20,000 by year’s end or, better yet, is on the verge of careening into the abyss, and brother you’ve got ratings!
But it’s all just so much foam, fluff and noise. It doesn’t matter to us.
We’re in it for the beer!