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Plugging The Gap Thumbnail

Plugging The Gap

Investing

For more than 15 years, I’ve taught sessions in the award winning “It’s Your Money” (IYM) program. IYM is a six-week program that covers basic financial planning and investment topics. Classes are taught by fee-only advisors and are available for free through several libraries and senior centers throughout Orange County.

Recently, I taught their “Equity and Fixed Income Investing” course. Since 90 minutes is not nearly enough time to deeply cover this topic, my approach has been to introduce the basics and then provide the top things I think everyone should know about stocks and bonds. (Reach out if you’d like a copy of my presentation.)

In my most recent talk, I shared these five things about equities (“stocks”):

  • Stock Prices Fall Frequently
  • Don’t Follow Your Gut
  • Don’t Jump In/Out of the Markets
  • International Stocks May Start To Lead Once Again
  • Don’t Pick Stocks, Most Professionals Underperform Index Funds

With the recent volatility we’ve seen, I thought I’d share more about the Don’t Jump In and Out of the Markets slide I present. 

This chart shows the performance of several investment types (“asset classes”) from 2001 to 2020. Working left to right on the chart, REITs (real estate) were up 10.0% a year over that 20-year timeframe, Emerging Market stocks were up 9.9%, (and so on), Cash was up 1.4%, and Commodities (gold, silver, oil) were down 0.9% over that period.

What are the lessons I take from this chart:

  • Stocks tend to be better performers over longer timeframes. We see EM Equity, Small Cap, S&P 500 on the left (better performing) side of the chart. Bonds are in the middle of the chart. Cash is on the right (lower performing) side of the chart. This is typical for most 20-year periods.
  • This performance did not come without rough spells. The stock markets lost more than 30% of their value three times during this period. Despite these drops, we still see long-term outperformance. Higher long-term performance requires higher short- and long-term risk. 
  • Blended portfolios performed well and reduced the scary times. The chart shows two blue portfolio mixes: the 60/40 mix (60% in stocks and 40% in bonds) and the 40/60 mix. Both of these mixes earned around 6% over those 20 years – not bad at all.

My biggest takeaway comes from the orange bar on the right of the chart, representing the returns of the “Average investor.” Sadly, the average investor only earned 2.9% from 2001 to 2020. 

You might ask how the average investor can underperform almost all of the investment types out there. Again, riskier investments earned 6% to 10%, safer investments earned 4% to 5%, and blended investments earned 6% to 7%; why do average investors get much worse results? Sadly, the answer is primarily due to one thing: their behavior. (This is often called the “behavior gap.”) Investors tend to buy investments that have performed well and sell investments that have performed poorly – this is often the opposite of what they should be doing. Buying high and selling low costs them 3.5% to 4.5% a year in lost performance. 

As I build client investment portfolios, my first goal is to avoid this behavior gap. Sadly, professionals can fall prey to this gap as well. Three of the ways I do this are to: 

  1. take a long-term view to investing (thinking 3-5 years, not 3-5 weeks),
  2. diversify (owning holdings that do not act in lockstep, especially during the rough times), and
  3. rebalance wisely (trimming high and buying low).