There Is No Free Lunch
As Ben Carlson shows in his blog post “Investors in Search of 7-Minute Abs,” investors are always on the lookout for a way to earn big returns with no risk. And many con artists say they can deliver. This is why guys like Bernie Madoff get money. Everyone wants to believe. But great returns with no risk is an impossibility. Magical thinking is no way to manage your portfolio if you want to reach your financial goals.
Most Active Fund Managers Are Index-Huggers
Most active fund managers have low active share, which is how different a portfolio is from its benchmark. This means these managers amount to index huggers that don’t deviate that much from their benchmarks. This makes it very hard to outperform, even when we get the proverbial “stock picker’s market.” Of course, a fund with high active share can underperform as well as outperform significantly, but if you are in effect buying an index fund with higher costs, you aren’t going to be getting even the index returns.
Poor Investor Behavior Means Most Investors Don’t Get Fund Returns Even In Index Funds
When you look at the return data for your funds, you likely assume they represent your returns. Au contraire! As Morgan Housel shows here, the average investor in Vanguard’s S&P 500 index fund earned 1.9% per year less than the fund’s indicated returns. Why? Bad investor behavior. We tend to buy high and sell low. So if you are actually getting index returns, you are an above average investor! If so, congratulations on your mastery of your emotions. Focusing on controlling your behavior is likely to bear more fruit than chasing hot returns. Know thyself!
The Hedge Fund Myth
People drool at the idea that they can get one of the elite hedge fund guys to manage their money. And the hedge funds certainly promise big returns. Here are some hedge fund mandates from Bloomberg:
“Expects a return of 10 percent to 15 percent and drawdowns of no more than 5 percent to 10 percent.”
“Managers should have a strong pedigree and expect a return of at least 12 to 15 percent in the coming quarters.”
“The firm generally targets returns of 15 percent and volatility should be 7 percent.”
So how have they done against those promised big returns? Pretty lousy. Over the last decade, 2 major hedge fund indices are both negative.
And if you say you don’t want average, you want the cream of the crop, those legends aren’t taking your money. So, never mind.
What Is An Investor To Do?
So it all comes back to managing your own behavior and lengthening your time horizon. Patience and equanimity are the individual investor’s advantages over the pros who are focused on the next couple of quarters.
And for active investors I submit the following formula from Todd Wenning:
Investing Success = Good Company + Right Price + Investment + Patience
Simple, but not easy. But it’s the only game in town for real investors. Otherwise, you’re just taking your chances speculating in the casino at the corner of Wall and Broad Streets.