By Bob Wood, Muslim Media News Service (MMNS)
We see no lack of stock market bulls in the mainstream media these days. Perhaps regular readers of this column return for their predictable weekly blast of cold water to the face! This strategy is the best I know to help investors wake up to the reality of what the stock market is — and what it is not.
Todayâ€™s bullish stock market promoters repeat over and over again that the stock market is a road to riches. Just look at those new record highs for major indices like the Dow or the Russell 1000, and there you go. What more evidence would you want?
Well, a couple more pieces of evidence would help convince me of the bullish case, but those pieces are still missing. And they are big ones, too! One such piece of corroborating evidence would be the existence of wealthy stock market investors. While I am sure that some people out there have generated fortunes from investing in stocks, no one that I ask seems to know exactly where they are. Do you?
On the face of it, this is truly odd, isnâ€™t it? Bullish â€œexpertsâ€ like Jeremy Siegel, who wrote Stocks for the Long Run, assure investors that all they need do is diversify and let time work in their favor. In the long run, they purport, stocks always head higher. So if you wait long enough, you will enjoy the fruits of your patience and sacrifice.
Corroborating evidence includes those wonderful, long-term, historic returns earned by mutual funds. Data tables are full of positive gains earned over long time periods by the more popular funds. So obviously, any investor who rode patiently along with any of them made big money, right? The only thing wrong with this statement is that we seem to have a glaring lack of patient investors.
And while these long-term returns look impressive, no one seems to see them actually add up in their accounts. This result applies to major market indexes like the Dow, for which we have a long data set to examine.
Letâ€™s examine some other pieces of evidence to determine whether I might be onto something here. First, consider some data brought to light by Ed Easterling, quoted in a book, Just One Thing, by John Mauldin. He points out that, while the average annual return on the Dow shows a gain of close to 10%, calculating the Dowâ€™s compound return over the past 106 years produces an average annual gain of about 5%!
We can easily replicate his method by plugging a few numbers into our financial calculators, using 66 as the Dow value in 1900 and then comparing it with todayâ€™s value. I just did the calculation and got a result of 5.14%. Do you still wonder why we find so few wealthy stock market investors? Doesnâ€™t this simple math help illuminate the answer a bit?
Letâ€™s add to our discussion some recent evidence offered by Barrons. In the mutual fund section of the June 18, 2007 edition, an article reports returns advertised by funds companies versus actual returns realized by buyers of shares in them. Oddly enough, a big discrepancy exists between the fundsâ€™ records and the experience of many fund investors.
One fund mentioned is the Calamos Growth A Fund, a mid cap fund. While the fund sports a 10-year return average of 18.75%, the average return realized by its investors is 9.76%. For the Vanguard Growth Index Fund, the gain advertised for the past 10-year period is 6.29%. However, the fundâ€™s average investor profit is just 1.81%. For the Legg Mason Partners Aggressive Growth A Fund, gains posted by the fund average an annual 14.33%, but the average investor earned only 7.83%!
Now, those are big differences, arenâ€™t they? This variance is becoming enough of a concern that Morningstar now offers data on both the average annual return earned by many funds and the average annual gain earned by their investors. For some funds, big differences exist. For others, we see little, if any, difference. Interestingly, the fund family advertising on this page seems to cater to very patient investors, showing return numbers that are almost identical. (And no, I donâ€™t know these people, nor have I spoken with them. Whether you invest in that fund or not doesnâ€™t concern me in the least. Iâ€™m just passing along an observation.)
Also in the Barronsâ€™ piece is an attempt to assign responsibility for the lowly investor returns as compared to average annual gains made by the funds themselves. Can you guess who gets the blame? Why, of course, itâ€™s you! Well, itâ€™s that â€œnervousâ€ investor, who apparently buys high and sells low with alarming consistency.
The investment research company Dalbar also does some great work in this area. That firmâ€™s Lewis Harvey added to the Barronsâ€™ article that â€˜â€™the average equity investorsâ€™ annualized return between 1986 and 2005 was 3.9%, while the Standard and Poorâ€™s return was 11.9%.â€™â€™
This information provides an update to citing of the Dalbar work, which I first read a few years ago in the book Why Smart People make Big Money Mistakes, written by Gary Belsky and Thomas Gilovich. In it, they quoted gains earned by the average investor compared to market averages.
â€˜â€™From 1984 through 1995 the average stock mutual fund posted a yearly return of 12.3%, while the average bond mutual fund returned 9.7% a year. From 1984 through 1995 the average investor in a stock mutual fund earned 6.3%, while the average investor in a bond fund earned 8%.â€™â€™
Iâ€™ll wait while you take time to read those numbers again.
Now keep in mind that the period cited above was one of very favorable returns, albeit with that nasty bear period in 1987 included. But one could be easily led into thinking that because the average annual gain posted by many mutual funds was so positive, their investors must have done quite well. But this is clearly not the case!
In fact, during both time periods shown by the Dalbar work, the average investor would have fared better by avoiding stocks altogether — and that was during bull markets! The average investor would have earned more by investing in bonds for the whole time!
As mentioned above, the investor gets the blame for the difference in realized gains over long time periods. They tend to chase performance and take the easy way out when analyzing their investments. And for the most part, this concept is true. How many still invest in companies they know nothing about, having heard a hot stock tip from a friend or by listening to financial media promoters touting this stock or that?
Where I have a hard time assigning all the blame to the investor is that this accusation seemingly assumes that all investors manage their own accounts. But what about the millions of accounts managed by â€œprofessionalâ€ brokers and advisors? Is there any difference in the gains made by the class of investor who pays the costs of professional advice?
In the short list of funds provided above, where major return discrepancies are shown, two of the three funds are â€œloadâ€ funds. How many â€œdo-it-yourself investorsâ€ buy mutual funds requiring an up-front sales fee? I donâ€™t have that exact number at the moment, but Iâ€™d guess it must be close to zero!
But the investor still gets the blame! Why do you suppose that happens? Could it be that many investors shove their brokers and advisors around, telling them what to buy and sell in spite of strenuous objections from their seasoned professionalâ€™s best advice? Yeah, that looks like a pretty weak argument, doesnâ€™t it?
But you didnâ€™t expect the brokerage community to accept any of the blame, did you? Yes, the big brokers have been around for decades, yet we still find an amazing lack of successful investing stories. And with huge amounts of broker-assisted mutual fund and stock buying and selling occurring in the past 50 or more years, we still find few examples of really successful investing.
Itâ€™s not that investing is an impossible pursuit. Finding low cost, no-load mutual funds with strong managers still makes sense for patient investors. But recognize, going into the game, that no magic formulas or short cuts apply. Investing takes time and patience. If you find a fund you are happy with, stick with it for as long as you can justify it. Donâ€™t let short-term disappointments push you into making bad decisions.
If you are using the services of brokers or advisors, start asking hard questions about their track record and how many of their investors have made small fortunes over the past 20 years. I think you will find that professional advice always has its costs — but often offers little benefit.
This evidence seems to prove itself again and again, over long time periods — and even during the best bull markets of the recent past. Donâ€™t let promotersâ€™ claims fool you into thinking that the stock market offers the easy road to riches. It does not — even in the best of times.
Have a great week.
Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., firstname.lastname@example.org.