Why Investing in Mutual Funds is Just Not Smart

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As the small print says on the bottom of every piece of financial literature, “past performance does not guarantee future results”. It is a fact that returns do not persist. Unfortunately, human behavior has us chasing last years “bests”, and it is a recipe for disaster.

John Bogle, founder and former CEO of the Vanguard Group stated:

“Good markets turn to bad markets, bad markets turn to good markets. So the system is almost rigged against human psychology that says if something has done well in the past, it will do well in the future. That is not true. And it’s categorically false. And the high likelihood is when you get to somebody at his peak, he’s about to go down to the valley. The last shall be first and the first shall be last.”

In other words, last years losers could be this years winners and vice versa.

Here is an example. Highlighted, are both the S&P 500 Growth and Emerging Market indexes. As you can see, the returns vary. Whichever one is at the top in some years, tends to be at the bottom in the following. By the time the performance is visible, and an investor decides to buy, that particular investment has already gone through most of its normal cycle of gains and is nearing the end; causing one to buy high, which in turn leads to one selling low.

Secure Investments

As Lance Roberts has stated,

“Performance chasing has a high propensity to fail, continually causing investors to jump from one late cycle strategy to the next”.

You might say, “I am different. I won’t follow that route.”

The numbers would disagree.

Here is a study conducted by Dalbar, a Boston, MA based independent research company. They try to determine why investors constantly under perform the market; the company recently released their 22nd annual “Quantitative Analysis of Investor Behavior”. Here is what they found at the end of 2015:

  • In 2015, the average equity mutual fund investor underperformed the S&P 500 by a margin of 3.66%. While the broader market made incremental gains of 1.38%, the average equity investor suffered a more-than-incremental loss of -2.28%
  • In 2015, the average fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by a margin of 3.66%. The broader bond market realized a slight return of 0.55% while the average fixed income fund investor lost -3.11%.
  • In 2015, the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.
  • No evidence has been found to link predictably poor investment recommendations to average investor underperformance. Analysis of the underperformance shows that investor behavior is the number one cause, with fees being the second leading cause.
  • Acting in the investor’s best interest should include affirmative practices to curb harmful behaviors.
  • Asset classes tend to move together during market corrections, somewhat muting the benefits of diversification and necessitating a downside protection strategy that goes beyond traditional diversification.

safe investment options

The 30 year return for the average equity fund investor is 3.66%, barely outpacing inflation during the same time period, by only 1.06%.

This is proof that behavior and intentions do not align. And that emotional bias plays a large part in how investors make poor decisions.

Dalbar outlines nine investment behavior biases and psychological traps which lead to under performing the market:

  • Loss Aversion – Expecting to find high returns with low risk.

  • Narrow Framing – Making decisions without considering all implications.

  • Anchoring – Relating to the familiar experiences, even when inappropriate.

  • Mental Accounting – Taking undue risk in one area and avoiding rational risk in others.

  • Diversification – Seeking to reduce risk, but simply using different sources. Not avoiding systematic risk.

  • Herding – Copying behavior of others even in the face of unfavorable outcomes.

  • Regret – Treating errors of commission more seriously than errors of omission.

  • Media Response – Tendency to react to news without reasonable examination.

  • Optimism – Belief that good things happen to me and bad things happen to others.
The ones which play the most significant role on why investors fail, are: herdingdiversification, and loss aversion.
 

Investors lack true diversification. Reason being, there are mainly eight different types of risk; interest rate risk, inflation risk, reinvestment risk, political risk, regulatory risk, liquidity risk, unsystematic risk (business risk), and systematic risk (or market risk). Most investors are only limiting themselves from business risk, and they do this by having investments spread out in various mutual funds or index funds, as opposed to investing in specific securities. For another discussion at a  later time, I would also argue how most investors do not avoid regulatory (tax law change) and liquidity risk.

When you buy into mutual funds, the chances of  failure in a particular industry or business, is spread out in the pool of funds you are invested in. What this DOES NOT accomplish is in avoiding market or systematic risk. This, on the other hand is UNAVOIDABLE within the conventional manner of financial planning. This is the type of risk investors face when the general market for securities declines; examples of this would be the early 2000 meltdown and 2008 mortgage crisis. The issue with systematic risk is how THE FINANCIAL SYSTEM FAILS, and crosses asset classes. Leaving most Americans trying to go up river without a paddle.

Click here to learn more about the different types of risk. Or here.

Herding is when you are copying or following what everyone else is doing which causes one to sell low and buy high. This behavior plays a pivotal role in why investors continue to fail. When the market is performing well, people are led to believe that the trend will continue. Causing investors to stay in too long, as well as bringing in the last of the people who were holding out.

  • In a 2014 study conducted by Roger Ibbotson, a professor of finance at Yale, and Thomas Idzorek of Morningstar found that performance chasing is a recipe for failure. They found using a period from 1972-2013, that the least popular stocks had a return of 15.5% when the most popular stocks returned 8.3%. This study included analysis of three thousand individual stocks.
  • As reported by Barry Dyke in his book Guaranteed Income, in 1999 investors flocked to internet stocks which were listed on the NASDAQ, which rose 86 percent in 1999; by 2014, three fourths of the companies listed on the NASDAQ between 1999 and 2000 were no longer on the exchange.

Loss aversion, or the fear of loss outweighing the potential for gain, causes one to withdraw their money at the worst possible time. Once at the peak of the roller coaster, there will be an inevitable fall; however, it takes some time for most investors to realize this fall is more than just a dip in the cycle, and as the losses mount, panic sets in, causing people to avert from further destruction. This leads them to the behavioral trend of fear and panic, and they sell low.

In a vacuum, studies do show that buy and hold or passive indexing strategies will work over very long periods of time; however, the truth of the matter is very few investors will either stomach the downturns in order to reap the rewards, or simply buy in at the wrong time.

  • In the 2015 study (noted above) Dalbar found that the average investor only stayed with an equity mutual fund for 4.10 years, an asset allocation fund for 4.54 years, and with a fixed income mutual fund for 2.93 years. These retention rates inform us that investors continually lack the patience and long term vision to stay invested in a particular mutual fund for more than four years (I won’t even get into the high turnover of fund managers and how that affects you).

The goal of every investor is to take actions that will significantly reduce the destruction of capital over time, while maximizing its appreciation, and as the numbers prove, the results do not align with intentions.

alternative investments
Return of $1,000 invested on March 24, 2000 through March 31, 2016

The problem with any investment regarding Wall Street, whether managed or passive, is that YOU the shareholder put up 100 percent of the money, and YOU take 100 percent of the risk. As shown in the graph, you bear all the risk of loss, for a compound annual return of 3.75%?

I understand. Where else can you put your money with the Federal Reserve lowering rates to basically zero, practically forcing you to place your money in the market in order to keep up with inflation (which they themselves create).

 

Consider Occam’s Razor

Where there are multiple solutions to a problem, choose the simplest one. There are more than 7,923 different mutual funds, and over 1,411 exchange traded funds in the United States (as reported by the 2015 Investment Company Institute Fact Book), does that at all sound like a simple choice to make?

If not there then where to Invest?

Bridge Loans and Hard Money: An Alternative Investment

Believe it or not, there are investments that do not reside in the stock market casino. One example, which has predictable results secured by real assets is a First Position Commercial Mortgage or Bridge Loan. These investments also take out a lot of the emotional biases that continually cause investors to fail, they are easy to understand, and you will not fall prey to Wall Street speculation and corrupt government officials.

Bridge loans, if handled properly (I say if handled properly because there are riskier ways to get involved), fall under the Author of The Intelligent Investor Benjamin Graham’s philosophy:

“An investment operation is one which, upon thorough analysis, promises safety of principle and an adequate return. Operations not meeting these requirements are speculative.” 

These are first position private third party loans which are secured by real estate, mostly commercial. You, the private lender, will select a mortgage with a company after searching through their inventory. You are then recorded on the title, and acquire a first position lien. The company which you choose to do business with, will then pay you monthly interest payments at a fixed annual yield immediately, with the return of your principal at the end of the one year term.

  • short 1 year term
  • low loan-to-value ratios of 65% or less
  • high single digit fixed annual yields
  • immediate monthly payments from partnered company not the borrower
  • secured by real estate
  • recorded first lien position

How does having a first position lien benefit you? The first lien has priority over ANY other liens or claims on a property in the event of a default.

When dealing with bridge loans, you want to make sure you work with a company that does their due diligence. As in, they perform a proper title search to make sure there is an insured first lien position, pays off any existing lien holders, and conducts an in-depth appraisal to determine proper market value. You also want to make certain you work with a company that will lend their own funds, hold a second lien position behind you, and that will contractually obligate itself through Promissory Notes and Loan Agreements to pay the monthly interest payments and return the principal at the end of the term, regardless of default.

How does having a 65% or less loan-to-value ratio benefit you? Your funds are protected by hard collateral which has great value, so the lower the loan-to-value ratio the more equity you hold, which is what protects your investment (regardless of the real estate market).

The stock market is a dangerous place to store and risk your hard-earned dollars. Unfortunately, that is where most people warehouse their wealth, and more often than not it is in defined contribution plans…which are very expensive and can be among the most volatile if you are in a target-date fund. When it comes to your portfolio, you must have some allocations towards products that have protection for your principal and won’t leave you out to dry. Something that can take your human instincts and behavior out of it. Once you have the majority of your money warehoused in savings (I recommend high cash value permanent life insurance backed by a company’s general account), you can then invest, and first position mortgages or bridge loans, are a great alternative.

You can get started with qualified funds (retirement accounts) through a self-directed IRA or non-qualified funds.

The reality is, you MUST be focused on protecting your capital at all times. The sad truth for most Americans is YOU are putting up 100% of the capital, and YOU are shouldering 100% of the risk. Meanwhile, Wall Street cares only about their Assets Under Management or AUM; which is a non-stop income stream. As reported by Morningstar in an April 2015 study. They concluded that fee revenue from mutual funds and etfs is at an all time high at $88 billion at the end of 2014, up from $50 billion 10 years prior. AUM grew 143% and the industry fee revenue grew 75%. You see, whether or not the market goes up or down…they will always collect their fee; always. Not to mention the “revenue sharing arrangements” that is all over Wall Street, which in any other industry is called a kickback (here is an example, or an example of overcharging one’s clients click here).

If you would like to learn more about how to protect yourself from market speculation, go to my contact page and provide your name, email, and message.

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