Everyone Is Not Losing Money:
Investment Myths and the Unnecessary Investment Losses They Create
James W. Watkins, III, J.D., CFP®, AWMA®
Financial advisors often explain investment losses with the mantra “it’s the economy, everyone is losing money.” When an investor asks me to perform a fiduciary audit and tells me that that was the explanation given to them for the poor performance of their portfolio, I tell them that statements like that generally reveal one of two things – their financial advisor is either intellectually dishonest and cannot be trusted, or the advisor does not really understand wealth management, especially portfolio risk management.
The investment industry has created a false sense of security in investors by perpetuating, either intentionally or unintentionally, various investment myths. In many cases, investors have read or heard these myths so many times that they have come to accept these myths as true, without taking the time to actually determine their accuracy. Unfortunately, investors often suffer unnecessary investment losses as a result of their blind acceptance of such myths.
People in the investment industry may react strongly when such accusations are made. However, a review of the 2000-2002 and 2007-2008 bear markets raises legitimate questions regarding the role that popular investment myths and misconceptions played in contributing to the bear market losses suffered by investors. The purpose of this paper is to consider some of the more popular investment myths and examine how they can negatively impact an investor’s returns.
1. It’s the market/economy. Everyone is losing money
A recent Wall Street Journal article discussed “The Lost Decade” of investing, as the 2007-2008 bear market effectively wiped out the market’s gain over the past decade.1 Even intermittent periods of volatility can have a significant impact on investment returns. Consequently, consistency of returns and the avoidance of large losses are keys to successful investing.
Too many investors get so caught up with maximizing returns that they fail to consider the importance of preserving their gains through an effective risk management strategy. A popular saying on Wall Street is “don’t confuse brains with a bull market.” This saying reflects the fact that approximately two-thirds of all investments follow the direction of the prevailing trend of the market. Therefore, it is actually hard not to make money during a secular bull market.
The real key to investment success is how well investors use risk management techniques during bear markets to preserve their wealth. It is for that reason that Charles Ellis points out in “Investment Policy: Winning The Loser’s Game,” that the true value of an investment advisor lies more in their ability to manage market risk than in their ability to generate investment returns.2 Effective investment risk management can range from simple strategies, such as reallocating and/or replacing current assets, to more complex strategies using bear/inverse index funds or options to protect an investor’s portfolio.
In some cases, other investment myths contribute to a failure to implement appropriate risk management strategies. In other cases, conflicts of interest may prevent the development of an effective risk management plan. Regardless of the reason, a failure to properly manage investment risk needlessly exposes an investor to the risk of significant financial loss.
2. Stockbrokers, investment advisors and other “financial advisors” are required to always put their clients’ interests first and to disclose any actual or potential conflicts of interest.
Investment advisors, including financial planners, are, by law, fiduciaries. As fiduciaries, they are held to the highest standards in connection with their dealings with the public. Fiduciaries are required to always put their clients’ interests first and to disclose any actual or potential conflicts of interest.
Stockbrokers, on the other hand, are generally not considered to be fiduciaries. Consequently, they are not required to put their clients’ interests first or to disclose all information regarding actual or potential conflicts of interest. Unlike fiduciaries, who are required to only recommend investments that are in a client’s best interests, stockbrokers are only required to recommend investments that are “suitable.”
Hopefully, the recent Dodd-Franks legislation will result in a universal fiduciary standard that requires anyone providing investment advice to the public to always put the client’s interests first. However, the Bernard Madoff case and the monthly list of enforcement action on both the Financial Industry Regulatory Agency (FINRA) and the SEC web sites prove that simply enacting rules alone neither ensures that financial advisors will comply with such rules nor guarantees the quality of investment advice an investor receives. While FINRA, the SEC and state regulatory departments audit broker-dealers and investment advisory firms, they have neither the time nor the resources to review each customer account, each recommendation and each transaction made within an account.
In theory, the internal compliance department in each broker-dealer and investment advisory firm should be able to detect and to prevent improper activity by their representatives. Unfortunately, as is often the case, there are too many cases where theory and reality produce different results. Bottom line, investors must become more proactive and take greater responsibility for managing both their financial advisors and their financial affairs in order to protect their financial security.
3. Modern Portfolio Theory’s “optimal” investment portfolio is the best investment option for every investor.
The concept of Modern Portfolio Theory (MPT) and its use in creating the “optimal” investment portfolio was introduced in 1952 by Dr. Harry M. Markowitz. Prior to Dr. Markowitz’s work, investment portfolios were usually created by considering only an investment’s returns and the variance of such returns. Dr. Markowitz argued that the correlation of returns should also be factored into the investment portfolio construction process.
Many financial advisors use MPT-based commercial software programs to prepare asset allocation and portfolio optimization recommendations for their clients. Clients are usually given various spreadsheets and multi-color charts, along with the advisor’s asset allocation/portfolio optimization recommendations for the “optimal” investment portfolio. In truth, the charts, the spreadsheets and the recommendations generally do little more than create a false sense of security for investors and provide recommendations that may be totally inappropriate for the client.
What many investors, and for that matter their financial advisors, do not realize is that Markowitz himself cautioned that the most efficient investment portfolio based on MPT, the “optimal” portfolio, is not always the appropriate choice for every investor. Markowitz pointed out that in designing the proper portfolio for an investor, both an investor’s willingness to accept investment risk and their ability to bear such risk must be considered.3
Another reason why investors often suffer unnecessary losses as a result of MPT’s “optimal” portfolio approach is that the calculation process used by MPT is inherently unstable and easily susceptible to manipulation. MPT uses a process known as means-variance optimization (MVO) to produce asset allocation recommendations. MVO has an inherent bias toward investments that have high returns and a low level of variance in returns. Slight errors in the input data can result in disproportionately larger errors in the recommendations produced, leading one expert to characterize MPT-based portfolio optimization software programs as “estimation-error maximizers.”4
Another concern about relying on MPT-based recommendations is that the value of such recommendations depends on the reliability of the input data used, the proverbial “garbage in, garbage out” syndrome. Most MPT-based commercial software programs use historical risk and return numbers for their input data, even though “past performance does not guarantee future performance.” Markowitz himself preferred that estimates of future returns and variances be used in MVO calculations. However, the difficulty in predicting the future and the potential financial consequences for being wrong on such predictions makes the reliance on such “guesstimates” troubling.
Too often, MPT is simply a means to an end, a quick way to produce a financial plan to justify a fee and/or to market financial products, with little or no consideration given to the inherent value of the plan’s recommendations. Once a financial plan has been prepared, an investor should always ask the financial advisor who prepared the plan to go back and recalculate the plan’s projected risk and return numbers based upon the financial advisor’s recommendations or the actual investments sold to the investor.
The overwhelming majority of financial advisors cannot perform such investment specific calculations, as commercial asset allocation/portfolio optimization software programs are generally limited to performing calculations based on broad, generic asset allocation categories. Consequently, many critics of such pseudo financial planning argue that such plans are nothing more than expensive paper airplane and origami kits.
4. Asset allocation explains 93.6% of the investment returns of an investment portfolio
This statement is based on a 1986 paper by Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower (BHB) entitled “Determinants of Portfolio Performance.”5 BHB studied 91 large pension plans and analyzed the plans’ returns based on the plans’ allocation among three investment options – stocks, bonds and cash. Based on their study, BHB concluded that investment policy (i.e., asset allocation) “explained, on average, 93.6% of the total variation in actual plan returns.” 6 (emphasis added).
The main thing that investors need to know about the BHB myth is that BHB studied the determinants of the variation of returns, not the determinants of the total returns themselves. Variability of returns is significantly different from total returns, with no absolute correlation between the two.
In retrospect, the BHB findings are not that profound. Historically, stocks are more volatile than bonds and bond are more volatile than cash. Therefore, not surprisingly, the BHB study simply concluded that increasing the percentage of a portfolio’s allocation in riskier investments increases the variability of returns, or volatility, of the overall portfolio.
BHB never claim to have examined the impact of asset allocation on determining actual portfolio returns, let alone claim that asset allocation explains 93.6% of a portfolio’s actual returns. The investment industry, however, has manipulated the findings of the BHB study and combined it with yet another investment myth to promote perhaps the most devastating investment myth of all.
Subsequent studies have disputed BHB’s findings and the exact impact of asset allocation on portfolio management. The important point for investors is that asset allocation is an important aspect of the wealth management process, although just one aspect of the process.
5. A buy-and-hold approach is the best way to manage one’s investments.
Combine the MPT myth with the BHB myth and you get the buy-and-hold myth. Neither Dr. Markowitz nor Dr. William F. Sharpe, both Nobel laureates for their work in the area of portfolio management, has advocated that a portfolio’s allocation mix should always remain static. In fact, Dr. Sharpe has stated that a portfolio’s allocation should be flexible in order to adapt to and to benefit from changes in the economy and the markets.7
Nevertheless, the investment industry continues to perpetuate the notion that the best investment strategy for investors is a buy-and-hold approach. Investors have heard or read about the buy-and-hold proposition so many times that they just assume that it is true, even though the history of the markets clearly indicates otherwise. While buy-and-hold works during secular bull markets and perhaps for certain specific investments, the buy-and-hold approach completely ignores the cyclical nature of the broad-based markets and the impact of secular bear markets.
Just ask index investors how well a buy-and-hold approach served them during the 2000-2002 and the 2007-2008 bear markets. Between October 2007 and November 2008, the S&P 500 Index lost 51.9% of its value. In order to recover the loss, an investor will have to earn a return of approximately 107.9%, not factoring in inflation.
Sadly, such losses could have and should have been either avoided altogether or at least mitigated had investors and their advisors heeded the market’s warnings. Buy-and-hold advocates generally ignore such “warnings,” arguing that such techniques constitute market timing and that market timing does not work. They are absolutely correct insofar as they are referring to classic market timing, which attempts to time short-term swings in the market.
However, the buy-and-hold argument becomes disingenuous when applied to intermediate and long term investing, as it completely ignores the cyclical nature of the broad based market and the value of avoiding significant losses. Responding to changes in the economy and/or in intermediate and long terms trends in the market by acting proactively to prevent unnecessary investment losses is simply intelligent and prudent wealth management, not market timing.
Just before the onset of the 2000-2002 bear market, the price-earnings ratio on the Dow Jones Industrial Average stood at an all-time high of 43, almost twice as high as the Average’s previous price-earnings ratio high and almost 150% above the Average’s historic average price-earnings ratio of 16-17. As a result of the dot.com craze, people were paying irrational prices for stocks of companies that had never even shown an annual profit. The question was not if there would be a bear market, only when it would occur.
Buy-and-hold advocates simply chose to ignore such signs, resulting in disastrous and unnecessary investment losses. As Aldous Huxley pointed out, “facts do not cease to exist simply because one chooses to ignore them.”
Buy-and-hold advocates also point to tax efficiency as an advantage of their approach to investing. While the tax implications of an investment strategy should always be considered, an investor should remember why they chose to invest in the first place, to make money in pursuit of their financial goals, and not allow the tax “tail” to wag the investment “dog.”
Since the defensive measures being considered here would presumably involve intermediate and long term investment holdings, any taxes that would be incurred would be based on the lower capital gains tax rate and not on the higher ordinary income tax rate. Ask investors who suffered losses of 40-50% during the 2000-2002 and 2007-2008 bear markets if they would have been willing to pay 15% in capital gains tax to preserve the value of their portfolios.
Given the evidence against using a buy-and-hold approach for intermediate and long term investing, one has to wonder why a financial advisor would advocate such a strategy for a client. Many investors may not realize that most actively managed mutual funds pay annual 12b-1 fees to financial advisors for as long as the advisor’s customers own their funds. Combine that fact with the fact that all financial advisors are not required to put their customers’ interests first and perhaps the steadfast advocacy of a buy-and-hold approach makes more sense.
6. Just wait, the market will recover.
This is not so much a myth as it is an incomplete and misleading statement. Markets generally do recover, but the time spent on recovering from losses is an opportunity cost since an investor must use those recovery returns just to break even from the earlier losses. It took almost six years for the S&P 500 Index to recover the losses it suffered during the 2000-2002 bear market. The NASDAQ Index has never recovered to it pre-2000-2002 bear market high. As mentioned earlier, an S&P 500 Index investor will have to earn a return of approximately 107.9%, not factoring in inflation, in order to recover the S&P 500 Index’s 51.9% loss during the 2007-2008 bear market.
Investors who are proactive and take defensive measures in order to protect their wealth get to accumulate more “true” wealth during the market’s recovery. As mentioned earlier, it may take buy-and-hold S&P 500 Index investors ten years or more to recover their losses from the 2007-2008 bear market. Simply put, it’s very hard for an investor to get ahead if they have to spend all their time catching up.
Lessons Hopefully Learned – Investor, Protect Thyself
In a 1999 speech, then Chairman of the Securities and Exchange Commission Arthur Levitt warned investors that they had to become more vigilant in their dealings with investment professionals and take greater overall responsibility for protecting their financial security.8 The wisdom of Chairman Levitt’s words was proven shortly thereafter with the 2000-2002 bear market’s revelation of various types of inappropriate activity on Wall Street, activity that seriously undermined the public’s confidence in the investment industry.
The impact of an investment loss is the same regardless of its underlying cause. This paper has discussed some of the common investment myths and misconceptions that cause or contribute to unnecessary investment losses for investors. Fortunately, the risk of financial loss due to such investment myths and misconceptions can be reduced by investors becoming more proactive in managing their financial affairs. Proactive wealth preservation steps investors should consider include
- developing and implementing effective investment risk management strategies;
- recognizing the potential impact that investment myths and misconceptions can have on an investment portfolio and adjusting a portfolio accordingly;
- replacing blind trust in financial advisors with a healthy dose of skepticism and a willingness to question financial advice;
- using experienced and truly objective third party experts to analyze existing or proposed investment portfolios and other financial matters.
- recognizing the difference in the disclosure and loyalty requirements for fiduciaries and non-fiduciaries such as stockbrokers and other “financial consultants/advisors,” as well as the potential financial impact of such differences;
- recognizing the inherent quality of advice issues with computer produced asset allocation and portfolio optimization plans;
The financial losses suffered during the 2000-2002 and 2007-2008 bear markets changed millions of investors’ lives. Despite allegations to the contrary, everyone did not lose money during these bear markets, at least not to the extent of the losses in the broad market indexes.
The unprecedented 1982-1999 bull market has led many investors to forget the historical pattern of two bullish periods and one bearish period over every three years. By failing to factor in the inevitable bearish periods in the markets, many investors have left themselves exposed to the risk of unnecessary financial loss.
Investors who use effective risk management strategies and ignore various investment myths and misconceptions increase their odds of earning acceptable returns in both bull and bear markets. On the other hand, investors who fail to respect the history of the markets and fail to properly manage investment risk should remember any financial losses from the recent bear markets and George Santayana’s warning – that “those who do not remember the past are condemned to repeat it.”
© Copyright 2009 InvestSense, LLC. All rights reserved.
This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.
1 E.S. Browning, “Stocks Tarnished by ‘Lost Decade’,” Wall Street Journal, March 26, 2008, Section A, Page 1
2 Charles D. Ellis, “Investment Policy: How To Win the Loser’s Game,” 2nd Ed., (Chicago, IL: Irwin Professional Publishing, 1993), 49
3 Harry M. Markowitz, Portfolio Selection, 2nd Ed. (Cambridge, MA: Basil Blackwood & Sons, Inc., 1991), 6-7
4 Richard O. Michaud, Efficient Asset Management: A Practical Guide to Stock Portfolio Optimization and Asset Allocation (Boston, MA: Harvard Business School Press, 1998), 36
5 Gary P. Brinson, L. Randolph Hood and Gilbert L. Beebower, “Determinants of Portfolio Performance,” Financial Analysts Journal 42 (July/August 1986): 39-48
6 Brinson, et al., 39
7 William S. Sharpe, Investors and Markets: Portfolio Choices, Asset Prices and Investment Advice (Princeton, NJ: Princeton University Press, 2006), 206-209
8 Arthur Levitt, “Common Sense Investing in the 21st Century Marketplace,” www.sec.gov/ news/speech/speecharchive/1999/spch324.htm