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Why Investors Cannot Outperform Simple Benchmarks

 3 min read / 

Many investors believe the ticket to riches is a superior investing strategy. If they can just get their hands on the secret formulas of the “pros”, they can make money every month of every year with minimal downside.

Many different strategies work, but not many investors earn the returns these strategies produce. Buy-and-hold works; contrarian works; value works; as does technical, trend-following and so on. However, many investors, continue to underperform implementing the strategy itself.

The reason? A lack of discipline. Many different diets get people lean and healthy, but not many stick with it long enough to work. They jump from one to the next and never get anywhere.

From December 1994 to December 2014, the S&P 500 produced an annualised return of around 10%; high-grade corporate bonds earned around 7%. The average investor significantly underperformed these two metrics, earning just a little over 3% per year.

This is a travesty. Professional investment managers feel extreme frustration at the prospect of investors underperforming a fund’s composite returns. If they allow their investors to get emotional about short-term ups and downs, they might make costly mistakes. The antidote to this is constant education and radical honesty when it comes to how investment decisions are made, what environments funds do and do not do well in, and what kind of volatility to expect over time.

Buy-and-Hold is loved by passive investors everywhere; easily beating hedge funds everywhere, right? Yes, maybe that has been the case lately, but investors, overall, routinely underperform. The index works well, but the breakdown occurs with us.

Think about how many buy-and-holders bailed out of the stock market during the Financial Crisis and then missed out on one of the best bull markets ever. There are plenty. How many investors would have bailed out if they understood the risks better — namely, that indexes can lose half (or more) of their value sometimes? Maybe investors could have stuck it out and then captured the subsequent uptrend.

All investment strategies work sometimes. Nothing works all the time.

Where investors and traders go wrong is not doing the work to understand how their strategy of choice works. Without this understanding, they do not know what kind of returns and losses to expect, when it performs well and when it struggles and how investment decisions are made. As a result, they get emotional when performance is not to their liking and they make rash decisions — often bailing out near bottoms and leveraging up near tops.

Lack of preparation and, then later, discipline promotes performance-chasing and hurts returns.

Fund managers need to do a better job communicating with their investors about how their strategies work and what kind of returns and losses to expect. Investors can then decide whether the investment fits with their own philosophy and risk tolerance and it improves the odds of them sticking with it through the inevitable ups and downs.

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