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Investor Behavior

A Little Hope is Effective…a Lot of Hope is Dangerous

By February 2, 2014October 25th, 2021No Comments

Hope. It is the only thing stronger than fear. A little hope is effective. A lot of hope is dangerous.

-Hunger Games

When it comes to trying to beat the markets, there’s a fine line between hope and delusion.

Consider that, as of a year ago, Americans had more than $7 trillion invested in 23,000 actively managed mutual funds—funds in which professional managers try to beat the market. They had only $2.5 trillion invested in “passive” funds, which merely attempt to match market indexes.

Overwhelmingly, investors believe they can beat the market, or find a professional to beat it for them. They just know it! Unfortunately, the numbers don’t back them up. Through the years, countless studies have demonstrated that – on average – passive investing beats active investing

Percentage of Active Funds Underperforming The Average Return of Low Cost Index Funds

Over the past three years, for example, the S&P 500 benchmark index has beaten 86% of large-cap fund managers, according to S&P Dow Jones Indices. The S&P Mid-Cap 400 index has beaten 86% of mid-cap managers. Even in the small-cap-stock arena, where managers are supposed to have the best chance to beat indexes, the S&P Small-Cap 600 index bested 80% of managers.

This is not to say that the best managers cannot beat the markets over time.  However, finding the next “Warren Buffett” may prove more difficult than one might hope.

And these are professional managers we’re talking about, people who are armed with formal training, tons of research and other advantages. If they can’t beat the market long-term, which of us can? The odds are staggering, yet hope springs eternal: Stock tips continue to flood the Internet, the airwaves and the newspapers, and Americans eat it up, almost always making themselves poorer in the end.

Part of what hurts active-fund performance is high management fees. The average mutual fund charges 1.5% a year in management fees, significantly trimming returns—or worsening losses. Then there’s the frequently overlooked matter of taxes.

Passive investing seeks to simply track indexes, which means there’s minimal trading and little tax exposure. Active investors, on the other hand, may frequently buy and sell as they seek to get an edge. This can increase capital gains exposure for portfolios that are held outside of tax-deferred accounts.

How much do taxes cut into investors’ profits? Recent research by investment advisory firm Gerstein Fisher found that, for the 15 years starting in 1998, actively managed stock funds lost .94% to taxes, compared with .51% for passive stock funds.

But nothing is more consistently damaging to investing results than irrational human behavior. Specifically we’re talking about humans’ seeming inability to be patient. We sell when the markets are scary, and we buy when they’re attractive. We chase rocketing stocks and mutual funds and then dump them after they come back down to earth. This pattern of market timing costs investors dearly. Over the 20 years through the end of 2012, the S&P 500 index returned an average of 8.21% per year, notes research firm Dalbar. But thanks to market timing, the average equity investor earned gross returns of just 4.25%.

The lesson is simple: Spending your mental and financial resources trying to beat the market is a no-win game. Our competitive urges are fine and good—but let’s steer them to the playing field, to our careers and to other appropriate channels. When it comes to investing, trying to beat the market consistently after fees, taxes, and irrational behavior may simply be hopeless.

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