The 4 Percent Solution
Why you're such a lousy investor.
It is a principle of American life—practically gospel—that you know better than anyone what to do with your money. The idea of privatizing Social Security is based on the notion that you'll invest your savings better than the government would. The ascendance of 401(k) plans over guaranteed employee pensions has the same foundation—that employees will make informed and prudent decisions when they invest.
But what if it's not true?
Over the last 20 years, the stock market has averaged a 12 percent annual return. But according to a study by Dalbar Financial, individual mutual fund investors earned only about 4 percent. A survey by Vanguard finds participants in its 401(k) plans earn only about one-half the average—6 percent a year. It is almost impossible to believe, and unpleasant to contemplate, but practically all individual investors are below average.
This is a problem that is beginning to be recognized. Since 1964 Nebraska offered state employees the chance to manage their 401(k)-type plan. Extensive employee education and training seminars were given, and everyone expected outstanding investment returns. But when the state audited the program in 2000, the results were incredibly discouraging—employees were making bad investment after bad investment. So in 2003, Nebraska eliminated employee choice from its 401(k) plan.
Pension funds directed by trustees achieve results that are about 50 percent better than those achieved by individual investors—even though trustees are not professional money managers. So why do individuals invest so poorly compared to institutions? When you compare individual investors to others, a few explanations suggest themselves.
When Diana Del Guercio and Paula Tkac compared the investment behavior of pension trustees and individual mutual fund investors for the Federal Reserve Bank in Atlanta, they found that the individual investors committed the classic market sin of chasing performance. When an asset manager begins to beat his peers by a large margin, pension trustees actually withdraw money from the hot-performing manager. Individual investors, by contrast, pour their money into those same asset managers. History shows today's high-performing funds are tomorrow's laggards, so individual investors are choosing investments that are likely to disappoint. Similarly, research shows that individual investors tend to sell securities that will have the highest future returns.
Individual fund investors are also much more reluctant to admit their mistakes than trustees are. Individual investors don't purge their bad investments, allowing poor performers to pile up in their portfolios. Pension trustees also do better because they usually engage professional advisers or consultants to help them make decisions.
The final reason individual investors do relatively poorly is more primal. Del Guercio and Tkac suspect trustees behave more rationally than individuals not because they are more financially sophisticated, but because they are more scared. Trustees have to answer for their decisions to a superior or a committee. It is very hard to hold a money-losing investment if your boss is holding you partially responsible for it. Individual investors can't be so objective about themselves. After all, we spend our lifetimes learning how to inflate our self-worth and deny our mistakes.
What's perhaps most surprising about all this is that individual investors seem to understand that they don't invest well. They actually don't want the responsibility for their investments. According to a Vanguard survey of its 401(k) participants, a whopping 85 percent of employees consider themselves unskilled investors and would rather have professional management. But consider this: The company's managers—the people who determine its plan design—tend to be in the small minority that wants personal control of retirement investments. In what might be called an act of divine retribution, Vanguard found that the poorest-performing investment accounts in its 401(k) plans belong to those employees who have the highest incomes.
Researchers Olivia Mitchell and Stephen Utkus * at Wharton's Pension Research Council looked at why the highest-paid individuals have the lowest returns. They conclude that richer participants tend to trade more and that is probably the source of their worse performance. Since individual investors tend to get the worse end of trades, it logically follows that any trading decision is self-defeating and the more trades made in an account the lower the returns.
Ed Dravo is president of Dravo Financial, an investment management company in Phoenix.