Some of You Must Fail

Bad news, investors. Some of you must fail.

Not probably, or unfortunately, but must. Professional, amateur. Hedge fund manager, day trader, indexer, 401(k) saver. Some of you must fail. It's a necessity of how markets work.

According to Dalbar and other research groups, the average U.S. stock investor has underperformed the market by between three and seven percentage points per year during the last 30 years, depending on how it's calculated. Most of this is due to what New York Times columnist Carl Richards calls the behavior gap: a parade of dumb decisions where the average investor buys high and sells low. This classic Carl sketch sums it up:

Source: Behaviorgap.com

Avoiding this behavior is the holy grail of successful investing. And some people -- many people -- can be taught to behave better. But the reality is that, as a group, we never can, never will.

Why? Because markets must always crash. Decades ago, economist Hyman Minsky wrote about a paradox. Stability is destabilizing, he said. If stocks never crashed, we'd all think they were safe. If we all thought they were safe, we'd rationally bid up prices and make them expensive. When stocks are expensive, the inevitable whiff of danger, uncertainty, or randomness sends them crashing. So, a lack of crashes plants the seeds for a new crash.

And what is a crash? It's people who bought high succumbing to selling low, falling for the same doom-loop behavior Carl's sketch portrays.

The reason stocks offer great long-term returns is because they are volatile in the short run. That's the price you have to pay to earn higher returns than non-volatile assets, like bank CDs. Wharton professor Jeremy Siegel once said, "volatility scares enough people out of the market to generate superior returns for those who stay in." Those are inspirational words for investors who assume they are brave enough to stay in; but not everyone can. The volatility that sets the stage for superior returns is just a reflection of someone getting scared out of the market in real time. 

Put this together, and you get an unfortunate truth that stocks offer superior returns for some because they offer a miserable experience for others. Without the misery, markets wouldn't offer big returns, and without the prospect of big returns, markets will crash and cause misery. That's why some investors must fail. 

All investors I know say they'll be greedy when others are fearful. They never assume that they, themselves, will be the fearful ones. But someone has to be, by definition. With stocks at all-time highs, few people will tell you, "If my portfolio falls 20%, I'm going to panic sell and cash out." They're more likely to say that a 20% decline would be a buying opportunity. This is the right attitude, but the reason there will be a 20% crash is specifically because investors choose panic selling over opportunistic buying. My experience is that most investors who say they'll be greedy when others are fearful soon realize that they are the "others." It has to be this way: When everyone thinks they're a contrarian, at least half will be wrong.

Soon after market meltdowns, journalists and financial advisors come together and ask: When will investors learn from their mistakes? How many times must we buy high and sell low before we learn to behave better?

I've come to realize the answer is "never." As a group, at least. If people stopped acting dumb, markets would be stable, and if markets were stable, they'd be expensive; and when they're expensive, people act dumb. It's a feedback loop that was true 1,000 years ago and will be true 1,000 years from now. I think it's an accurate description of what a market actually is.

Coming to terms with this taught me a couple things.

One, nothing that most people fail at is easy, so we shouldn't assume it's easy to watch our portfolios crash and remain unshakably calm, or stay levelheaded during a big rally. When the average investor doesn't come within hailing distance of an index fund, you're fooling yourself if you think investing will be an emotional cakewalk. Over time, the investor willing to endure the steepest emotional roller coaster will win.

Two, the best thing you can do to up your odds of success is to repeat to yourself, over and over again, that a market crash is not a bug or an indication that something is wrong. It is, quite literally, the admission fee for being able to earn superior long-term returns -- like a stressful work project that lets you earn a big bonus.

Best of luck to all of you, but my deepest sympathies to some of you.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

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Read/Post Comments (21) | Recommend This Article (83)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 16, 2014, at 12:07 PM, cooncreekcrawler wrote:

    Nice job and well said. Wish I had started earlier, but I finally learned the game.

  • Report this Comment On May 16, 2014, at 5:16 PM, PappyBlueRibs wrote:

    Very nice article!

    So, we're finally callin' it like it is, eh? People are idiots at times, we make basic mistakes, we're scared when we should be greedy, and greedy when we should be scared. If we say we aren't, we're just fooling ourselves.

    After that is said, exactly what is the Motley Fool doing? Educating us? Please...be honest with us and yourselves. You can preach and beg and write article after article, and we all (yourselves included) will make mistakes.

    For the typical investor, you can boil down ALL investment advice into a list no longer than a 1-sided piece of paper. The rest is just noise and confusion.

  • Report this Comment On May 16, 2014, at 8:31 PM, TheDumbMoney wrote:

    Nice job getting on top of Abnormal Returns, and nice piece.

  • Report this Comment On May 17, 2014, at 12:29 AM, mrvlad0 wrote:

    I think Charlie Munger would agree with your 2nd point:

    http://www.youtube.com/watch?v=3WkpQ4PpId4

  • Report this Comment On May 17, 2014, at 9:08 PM, Minow wrote:

    If I told you once, I've told you twice...The Motely Fool is a story line, we're buying their storyline for what its worth 3-years-buy and hold? "News flash folks I'm no idiot and I don't buy no body's story line, I don't buy and hold, and The Motely Fool should including candle stick charting into their investor's library and do away with those lame fundamental charts that they use ....and their story telling!

  • Report this Comment On May 17, 2014, at 9:50 PM, devoish wrote:

    Thanks for explaining one of the reasons pensions were so much better as retirement vehicles than 401k's or IRA's.

    Sadly two thirds of the USA does not earn enough money to invest, and over half the remaining third lose the time value of their investments selling low and buying high.

    Best wishes,

    Steven Cecchini

  • Report this Comment On May 18, 2014, at 9:22 AM, CatoTheEldest wrote:

    Misses a key point: it's not always the same people who buy high and sell low. There is a learning curve and THAT is what is unavoidable. Some never learn, that is true, but much more often it's the young and inexperienced just coming into the markets who haven't yet gotten control of their emotions. The fault isn't in our stars nor in our DNA, it's just a lack of experience.

  • Report this Comment On May 18, 2014, at 9:46 AM, TMFHousel wrote:

    <<much more often it's the young and inexperienced just coming into the markets who haven't yet gotten control of their emotions>>

    Do you have data showing that? My experience is it's the other way around: people nearing retirement and realizing they don't have enough money are the ones making poor decisions, as they buy high thinking it's the only way to grow their money and sell low in a desperate attempt to save what they have left. I don't know of any data showing a breakdown but I'd be curious.

  • Report this Comment On May 18, 2014, at 10:54 AM, Minow wrote:

    Investors-- don't bother to educate themselves either their too busy, or aren't interest in doing so and they should seek out the help of professionals to manage their investments. The elementary school system needs to teach investment based economic type class to kids. We need to create an environment that makes investing fun and interesting in the young minds so when they grow up investing will be common and first hand knowledge!

  • Report this Comment On May 18, 2014, at 7:21 PM, kyleleeh wrote:

    <<Thanks for explaining one of the reasons pensions were so much better as retirement vehicles than 401k's or IRA's.>>

    I've never seen a shred of evidence that pension managers are more immune to buying high and selling low then anyone else is. Ever taken a look at the real estate investments CALPERS made in the mid 2000s? or the returns they thought they predicted they would get on the stocks they purchased in the late 90s?

    No matter what "promise" or "guarantee" a pension makes it can't pay you with money it doesn't have.

  • Report this Comment On May 18, 2014, at 7:27 PM, kyleleeh wrote:

    *returns they predicted they would get

  • Report this Comment On May 19, 2014, at 11:25 AM, sparksinchitown wrote:

    Carl Richards book is one of my favorites!

    Available at the library. locals need to wait a week more for me to return it.

  • Report this Comment On May 19, 2014, at 11:39 AM, ramsanghera wrote:

    Good write up Morgan, as always !!!

    If emotions were not a key factor, investing would have been very simple ..

  • Report this Comment On May 19, 2014, at 1:40 PM, Almondfishing wrote:

    Great post. I would add that money is one of those unique symbols whose meaning is academically easy to understand, but emotionally very difficult to work with. We know that it stands for value spread out in many charts, accounting standards, etc. But put it in a stock or ticker, and it takes a life of its own in your life. I think that realize this power is a fundamental part of learning about investments.

  • Report this Comment On May 19, 2014, at 3:04 PM, CHill8008 wrote:

    <<<<much more often it's the young and inexperienced just coming into the markets who haven't yet gotten control of their emotions>>

    Do you have data showing that? My experience is it's the other way around: people nearing retirement and realizing they don't have enough money are the ones making poor decisions, as they buy high thinking it's the only way to grow their money and sell low in a desperate attempt to save what they have left. I don't know of any data showing a breakdown but I'd be curious.>>

    For what it's worth, data on age groups as a percentage of the population are easily had at the US census bureau website. I used this data in a model of to estimate adaptive expectations of inflation a few years back when getting my bachelors in econ. The data only goes back to 1980, and inflation is not s&p returns, but including only the older age groups consistently explained better the dependent variable than younger age groups. It does seem that people may learn over time (gain perspective, as I termed it in my paper), and that they learn under conditions of feedback (i.e. failure).

  • Report this Comment On May 20, 2014, at 1:13 AM, Dumbo47 wrote:

    what happens if everyone has a long term approach?

  • Report this Comment On May 20, 2014, at 7:43 AM, devoish wrote:

    kyleleeh,

    "I've never seen a shred of evidence that pension managers are more immune to buying high and selling low then anyone else is."

    I think that "never seen" is not the same as there not being any.

    What I do see is the millions who are retired and living on pensions, the volume of comments decrying excessive pension benefits of public employees as "stealing" when in fact they are the success story, and the incredible reduction in senior poverty achieved through publicly managed benefits such as medicare, SSI along with pension managers being salaried and therefore not sales or fee driven to mismanage or churn 401k investments for personal gain at the expense of their customer's employees.

    Best wishes,

    Steven

  • Report this Comment On May 20, 2014, at 2:55 PM, kyleleeh wrote:

    <<What I do see is the millions who are retired and living on pensions, the volume of comments decrying excessive pension benefits of public employees as "stealing" when in fact they are the success story>>

    They're decried as stealing not because they're successful, but because they're massively underfunded and will require a tax payer bailout to keep good on the promises they made.

    Why are they so underfunded? Because the pension managers bought high and told poititicians that double digit yearly returns could be expected for as far as the eye could see. Then reality kicked in and they realized they don't have enough money.

    <<I think that "never seen" is not the same as there not being any.>>

    I said I've never seen evidence that they are MORE immune to buying high and selling low then anyone else. That doesn't mean not one of them does it, it means that the average is no better then any private fund, and considerably less then just leaving it in an index...which is very easy to do with a 401K.

  • Report this Comment On May 20, 2014, at 3:45 PM, boogerface02211 wrote:

    You get it, dude.

  • Report this Comment On May 20, 2014, at 10:41 PM, devoish wrote:

    kyleleeh,

    You can convince me if you do not need to exaggerate.

    Calpers estimated 8% returns not double digits. Now I believe they are at 7.7.

    They are also just one of many pensions.

    Here is a comparison of institutional investment in the current rally vs retail investors.

    "Until very recently, as institutions were putting money into the market, retail investors were pulling out (keep in mind that globally the situation has been a bit different than in the US). Effectively retail accounts were "suckered" into selling shares to institutions at low prices. Early in 2013, retail investors stopped pulling money out and in the summer, just when equity prices hit new highs, they started putting some money in. That is why retail investor behavior remains a great contrarian indicator."

    But to be fair to you, it was not easy to find a comparison.

    http://soberlook.com/2013/08/global-retail-investor-behavior...

    Private fund managers are at the mercy of the decisions of the amateur 401k investor, who does make poor decisions, myself included.

    However if pension managers are no 'more' immune than anyone else, including any private fund then the whole game is a farce with fees charged. And the pensions are tat least cheaper.

    My company 401k charges .06% just to be in it (recently lowered) plus the management fees for the individual funds from a low of .01% for a S&P 500 fund to a high of .07% for a managed bond fund. And they are selling hard now, while the ten and three year returns look good.

    Best wishes,

    Steven

  • Report this Comment On May 23, 2014, at 8:13 PM, Lucaskasan wrote:

    From one of the comments, "The elementary school system needs to teach investment based economic type class to kids." Great idea. Would love to do it. In fact, I have done it twice: 2 different 3-week summer sessions.

    First, kids do not sign themselves up for these classes. Parents do reasoning it will "be good for them." So the teacher has a class of resentful kids.

    Second, math foundations are quite weak. Many high-schoolers cannot tell you 10% of a given number. They ask, "Can we use the calculator?" Even if they can get a right answer, they do not understand what the answer means.

    I think financial literacy should be an integral part of the K-12 curriculum, but such a proposal won't fly because the curriculum is already too wide and too shallow, and there are too few teachers qualified to teach fundamental math, let alone finance.

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