Sir Isaac Newton is considered one of the most brilliant scientists the world has ever known; famously remembered for formulating the laws of motion, universal gravitation and calculus. His brilliance did not extend to investing. Newton once remarked, "I can predict the movement of heavenly bodies, but not the madness of crowds."
Sir Isaac was an early investor in the South Sea Company (SSC), a monopoly established to trade in the South Seas in exchange for assuming England's war debt. In 1720, he cashed in his stake in SSC at a nice profit. Then he watched the share price continue to rise; and, like many investors since, he gave into temptation and bought back in, at three times the price of his original stake. When the dust settled, he lost almost his entire life savings (equivalent to $6 million in today's terms).
It would be more than 200 years after Sir Isaac's bad bet before the science of investing was established with Benjamin Graham's principles of security evaluation or Harry Markowitz's Nobel-Prize winning work on risk and return. Sir Isaac can be forgiven for his very human approach to investing because he didn't have enough information and choices to make an informed decision.
Fast forward to 2015 and everyday investors are deluged with information and choice. There are more than 35,000 mutual funds in Canada for investors to choose from. There are more than 6,000 exchange-traded funds listed globally. How about the fact that there are more than 46,000 publicly listed stocks to choose from around the world? How is today's investor going to choose?
According to researchers, the average holding period for US stocks has declined from seven years in 1960 to two years in 1992 to less than eight months in 2007. The comparable figure for 2014? It is estimated to be seventeen weeks! The story doesn't get any better with mutual funds or ETFs. Estimates from Vanguard, a large U.S. mutual fund and ETF company, suggest average holding periods of 3 years for mutual funds and 29 days for the twenty largest ETFs.
Unfortunately, frequent trading behaviour of individual stocks, predictably, contributes to investor underperformance. The Great Recession of 2008 and the ensuing volatility certainly scarred investors. But the era of low yields on cash and fixed income is not expected to change dramatically over the next few years so holding stocks for most investors is not an option but a necessity if they want to achieve long-term financial goals.
Recent academic research from the Netherlands indicates that portfolio turnover is lower in portfolios with an adviser than in self-directed portfolios; furthermore asset allocations are actually more conservative and diversified in advised portfolios than self-directed portfolios. Although this research did not discover evidence of significant outperformance or underperformance in advised portfolios, other research by Vanguard suggests that advice can add potentially up to 3 per cent in net returns through better behavioural coaching, asset location advice and regular re-balancing. Of note, Vanguard's research does not suggest that this added value can or should be expected annually; that it is more likely to be lumpy. But, an adviser who could have stopped Sir Isaac on from going back into SSC would have added immeasurable value to Sir Issac even if it was only a one time opportunity to provide advice.
Whether an investor is self-directed or advised having a disciplined investment process for choosing and holding investments is critical. As the sad case of Sir Isaac Newton shows, sheer brilliance cannot offset the emotions of fear and greed.
Sam Sivarajan is managing director and head of investments with Manulife Private Wealth.