Most of us mess up our portfolios so badly that we wind up with only about half the profits we could have pocketed. That sad conclusion is based on work from Dalbar, a research firm in Boston, which estimates that the typical investor in U.S. stock mutual funds over the past two decades earned a scant 4.25 per cent a year, despite a stock market that generated returns of 8.21 per cent during the same period. (On the chart below, we also show the results for bond investors.)
The chasm between what the market produces and what we put in our wallets is partly the result of mutual fund fees. Mostly, though, it's our own fault. Human beings show a perverse ability to jump in and out of stocks at precisely the wrong times. We're experts at sabotaging our own results.
All of this is galling. What makes our underperformance truly infuriating, however, are the simian superstars depicted in a recent paper by researchers at the Cass Business School in London. Andrew Clare, Nick Motson and Steve Thomas programmed a computer to simulate 10 million monkeys randomly selecting portfolios of 1,000 stocks each. They found that from 1968 to 2011, the cyber chimps would have beaten the market.
It seems odd that humans flunk the grade so badly when it comes to building their own portfolios, while a lottery-by-chimp approach beats the odds. But it all makes perfect sense if you look at three things most investment advisers won't tell you:
1. You're a step behind
Sure, you've done your research and developed a well-reasoned opinion about Tesla, Valeant or whatever. But here's the hitch: Unless you happen to be master of some arcane specialty, stock analysts have already gone where you've gone, totted up the same numbers—and already bid the shares up or down to reflect the results.
2. Join the crowd
Since the market is at least reasonably efficient at assessing all the available data, the smart strategy for most investors is to simply buy low-cost index funds – ETFs are the cheapest – that track the market. You'll do better than most investors, using a method that takes only minutes per year to implement.
3. But most indexes aren't perfect
Of course, if the market were truly perfect, those darned monkeys wouldn't be beating their (simulated) chests. Their success is a result of the imperfections in most market indexes. These benchmarks typically hold stocks based on their market capitalizations – the total dollar value of all their shares. A company with lots of shares, trading at excessive prices, will matter more to the index than a company with fewer, cheaper shares. The flaw in the market-cap approach is that it tends to put too much emphasis on companies with frothy stock prices and too little on out-of-favour companies that may be undervalued. This bias away from value is small but real. Monkeys can edge out a victory by picking stocks at random – since, over hundreds of selections, a traditional index has its results dragged down by its consistent overweighting of overpriced stocks.
Investors who want to take a chance and try to beat the market may want to look at alternative indexes such as those that weight their stocks equally, or those that factor in fundamentals such as earnings. Both of these approaches will give you an opportunity to look as smart as a monkey—and I mean that as a compliment.