The decade that just ended was an extraordinarily cruel one for investors, offering little or no return for the whole ten years. We almost had a recovery after the technology meltdown of 2000, but those gains disappeared in the credit-crunch-driven bear market of 2008/2009.
Against this backdrop of investor pain, a few mutual funds managed to do exceptionally well. One in particular, a U.S. fund called CGM Focus Fund, had an impressive 18.8% compounded return*. Anyone lucky enough or smart enough to pick that fund must have been handsomely rewarded – you’d assume.
The fund’s track record is undisputed, but let’s take a look at what its investors actually earned. Did they pocket that 18%? Sadly, no. The typical investor in this fund got a negative 11% return. In case you think that was a misprint, let me say it again: the typical CGM investor actually LOST 11%.
How can that be? The reason is one of the little-known facts about investing: there’s usually a big gap between “investment” performance, and “investor” performance. The culprit, as is often the case, is investor behaviour. If you buy an investment when it’s hot, then panic and sell it when things take a downturn, you often end up with a terrible result.
The CGM Focus Fund is a case in point. It had a remarkable performance, growing 85% over the course of a single year. Seeing this great result, eager investors piled into the fund. The following year, though, the fund dropped some 44% – and many of those same investors piled out. The fund then had another stellar year, prompting investors to return in droves – again, after the gain had already been made.
You can see a pattern here: the huge gap between investment return and investor return is more a matter of investor behaviour than market dynamics. This is true of both relatively obscure funds and stocks, and well-known ones. Look at any top-performing mutual fund, and the data tells the same story: capital flowing in at the peaks, and pouring out at the troughs.
In our present CNN-driven market culture, where trades can be made with the click of a mouse, it seems silly to stay with an investment when it’s losing money. Surely there’s a five-star fund someplace else that’s making money, while yours isn’t moving – so it seems sensible to sell the underperformer and get into the “right” investment.
The hard fact is, though, that markets reward investors for gritting their teeth and hanging in. If you look at any broad market index, like the S&P500, you’ll see extraordinary long-term returns. In 1970, the S&P500 stood at 72 points. Today, the figure is 1100 points. That’s money growing fifteen times! And if dividends were reinvested, you could add another few hundred percent.
Unfortunately, most investors don’t get that kind of massive return. Most of us seem to be hard-wired to behave badly when it comes to owning stocks. We either take extraordinary risk and choose just a few, instead of buying a diversified portfolio, or else we do diversify, but then buy at market peaks and sell at market troughs.
This isn’t because investors are dumb. We’re just responding to our defensive instincts: we can’t bear to see our hard-earned capital apparently melt away in a bear market. That’s too painful; we all prefer not to suffer.
But if there’s one thing I’ve learned from a lifetime of work studying the markets; it’s that the most successful investors are those who learn to live with the pain of a bear market. A good, diversified portfolio works best over long periods: twenty years is good, thirty years is even better.
During thirty years time, we can count on at least another four or five bear markets. For those of us who plan to live a long time, that’s great news. If we’re smart, we can reap big returns from that “risk premium.” All we have to do with our sensibly diversified portfolio is not sell.
*source: Morningstar
Alan MacDonald is an investment advisor with Richardson GMP Limited. Alan helps investors with over $500,000. of assets make smart decisions about money. For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com.
The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates.
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