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Below is an excerpt from Patrick O’Shaughnessy’s new book, Millennial Money: How Young Investors Can Build a Fortune, which is available from the link above.
There is one final aspect of long-term thinking that is very important for young investors. Because we are bombarded with stories about how difficult it is to beat the market, you may feel as though you can’t beat the market or the professionals over the long term. When I first started in the business, it seemed like the pros had an enormous edge over small individual investors. Many professionals that I met had earned their masters degrees in things like financial mathematics, had PhDs in economics, had studied 1,000 hours to earn their chartered financial analyst (CFA) designation, and had studied under experienced portfolio managers. But I learned that professionals, despite all their training and resources, have one huge disadvantage – they are beholden to their bosses and their clients, and their jobs are on the line when they perform poorly in the short term. To minimize their “career risk,” professionals make decisions that sacrifice large potential long-term rewards in favor of more secure short-term returns, or at least returns that are similar to the overall market. I’ve focused on 20- to 50-year investment horizons in this book because that is what millennials should focus on. But in professional investing, three years is an eternity. If a professional manager is losing to the market for three years running, he will often be fired and replaced with another professional manager, usually one that has done well in the past three years.
Clients evaluate managers’ performance at least once a quarter and sometimes once a month. These short time periods are meaningless in the market, but have become the standard for measuring performance. We’ve had many clients hire us and then threaten to fire us less than one year later because we’ve underperformed. This concern about short-term performance has repercussions up and down the money management business. Money managers want to do well for their clients (which can be individuals, institutions, pension plans, endowments, or foundations), but they also want to keep their jobs. If they underperform the market, or as a pension manager they hire managers that underperform the market, there is a good chance that they will be fired. Making bold decisions introduces “career risk,” because it increases the chances that their decisions will get them canned.
Sadly, lowering career risk also leads to lower returns. Many professional money managers have adopted a style known as “closet indexing,” so-called because their portfolios are so similar to the overall market that they might as well be an index fund. This lowers career risk because closet indexers won’t have years where they lose badly to the market. But we’ve already learned that being different is the real key to long-term success, so closet indexers also fail to beat the market by much. Once you account for their fees, these closet indexers aren’t worth hiring. The percentage of managers who are closet indexers varies by country, but most countries have a rather large percentage. In Canada, 37 percent of assets were with closet indexers in 2010 (see here). Several European countries have a closet indexing problem as well. Thirty-two percent of assets in the United Kingdom, 29 percent in France, and a whopping 56 percent in Sweden are invested with closet index managers. The United States is unique because it has among the highest percentages of indexed money (27 percent) but among the lowest levels of closet indexed money (15 percent) (see here). Closet indexing may help professional managers reduce their career risk, but they do so at the expense of their investors, who are paying active management fees for index-like returns. Across all 32 countries studied, the total annual costs to shareholders for true index funds is 0.35 percent, but the cost to shareholders of closet index funds is 1.64 percent. This is a huge cost for an index-like fund, and is barely lower than costs for funds that are different from the market, which cost an average of 1.66 percent. With such high fees, closet indexers have underperformed the market over time. Individual investors don’t have this problem, because individuals don’t have to worry about being fired for a bad year’s performance.
Another group that acts to reduce career risk includes plan sponsors – the people managing pension funds, endowments, and foundations. One way they manage career risk is to fire managers who have underperformed in the last few years and hire those that have performed well. When I was a kid my parents would tell me that we could do things the easy way or the hard way (ever the contentious contrarian, I’d often choose the hard way). Chasing recent performance is investing the easy way. It’s very easy to fire managers that are performing poorly and hire those that have done well in the recent past, because as humans we expect recent trends to continue. But a fascinating study confirmed that these hiring and firing decisions tend to be ill-fated. Amit Goyal and Sunil Wahal studied 3,400 different plan sponsors who made 9,000 hiring and firing decisions over a ten-year period. They found that managers being hired had outperformed the market by 3 percent on average, and that the number one reason for firing a manager was because they underperformed. Unfortunately for the plan sponsors, the managers hired went on to underperform the market (after fees), while many that they fired went on to outperform the managers that they hired!1
There are two key lessons here for the individual investor. First, even if the sophistication of professional managers makes it seem as though individual investors do not have an edge, they do. Without a job to worry about, individual investors can tolerate short-term underperformance on the path to long-term outperformance. Second, if you are to hire a professional manager (look for one that uses a strategy similar to the Millennial Money strategy), make sure that they aren’t a closet indexer charging active management fees. Find mutual funds or ETFs that are very different from the market.
A long-term mind-set
Whenever you feel the urge to do something with your portfolio because of what is going on in the market at the moment, ask yourself this question: looking back on this decision in ten years, will you believe that you made this decision for your long-term financial well-being or will you believe that you made the decision in response to short-term market circumstances? To imagine looking back on a decision sometime in the future can lend valuable perspective to a current decision. This question can also help you untangle yourself from the market’s mood. I am a junkie for Eastern philosophy and think that many core Eastern ideas – many of them thousands of years old – serve well as pearls of market wisdom. In a collection of the Buddha’s sayings called the Dhammapada, the Buddha tells us, “Do not give your attention to what others do or fail to do; give it to what you do or fail to do.” So much short-term behavior results when investors get caught up in the moment and caught up in what everyone else is doing and thinking. Don’t worry about what the market thinks or what the experts think. Worry about whether your behavior is good for you, and remember just how long an investing future you have ahead of you.
In the stock market, all news, crazes, and stock prices are temporary and transitory. Abraham Lincoln told the story of “an Eastern monarch [who] once charged his wise men to invent him a sentence to be ever in view, and which should be true and appropriate in all times and situations. They presented him the words, ‘And this too, shall pass away.’ How much it expresses! How chastening in the hour of pride! How consoling in the depths of affliction!” What Lincoln recognized in this simple phrase can be applied to our investing decisions. It is essential that in our hours of pride (and greed) and during our depths of affliction (and fear) we remind ourselves: this too shall pass. Ignore the news, ignore the experts, and remember that your long-time horizon gives you an edge over many professionals. In the stock market, time and patience are the most powerful warriors.
As you build your portfolios over the years, you will face many scary and many exciting markets that will make you want to sell in panic or buy in greed. Greed and fear, the push and the pull, are the two most destructive forces that we will face. They have ruined more portfolios than any market crash. They are the two strongest emotional influences that live in the short term – the here-and now. The next chapter discusses the middle way between these two emotional extremes, and why you must avoid the perils of both the push and the pull.
Patrick O’Shaughnessy is a principal and portfolio manager at O’Shaughnessy Asset Management (OSAM), a Connecticut-based investment management firm.
Read more articles by Patrick O'Shaughnessy
