In this month’s edition of “Money Matters,” Scott Oeth talks about why many investors trying to outperform and beat typical market returns usually end up falling far short, and how you can avoid becoming one of those investors.

Money Matters: Human Behavior & Investment Strategies Designed to Beat the Stock Market Transcript

0:00:00.1 CJ: WTIP is pleased to bring you another edition of Money Matters, a monthly feature intended to help us understand more about managing our finances. Scott Oeth is a Certified Financial Planner practitioner and adjunct professor. He's taught retirement planning and wealth management strategies to hundreds of financial professionals. And Scott joins us now by phone. Welcome, Scott.

0:00:22.0 Scott Oeth: Good morning, CJ.

0:00:23.1 CJ: Good morning to you. So in your notes, you said you wanted to talk about Minding the Gap. And I alerted listeners earlier that we were not talking about plumbers here.

0:00:35.7 SO: Nope, not this time!

0:00:36.7 CJ: Not this time, okay. So what is The Gap?

0:00:41.1 SO: Well, there's a big problem, CJ, in the investment world. And many people, classically, it's natural. They had this goal, they want to beat the market. They think that's what investment performance is about, having the investments they select outperform their comparative benchmark indexes. So it's a nice idea, but the problem is, what studies have shown us time and time again is that on average, most investors are actually falling far short of even achieving the market returns much less beating them. There's a well-known study by a group called DALBAR Financial Research Firm, and they study retirement plan flows. And they've consistently shown a shortfall. Their latest study (Quantitative Analysis of Investor Behavior (QAIB)) shows that over the past 20 years, a 1.5% annualized difference or gap between what the average investor earns and what the market's actually delivering. And so 1.5%, it's significant. But if we put that in dollar terms, if you'd started with $100,000 invested on December 31st of 2000, you go forward 20 years and look what the market actually delivered, that gap equals $100,000 of lost investment growth over that 20-year period.

0:01:51.0 CJ: What's going on?

0:01:54.0 SO: Well, this gap is a big issue, whether you have a large portfolio or even the more modest one, smaller dollar amounts, still real money. Morningstar, another prominent investment research firm just came out with their annual study. Looking at the same issue, they slice and dice it a little bit differently, but they call it the Mind the Gap study. And they found that over the last 10 years, they see a 1.7% gap. It's nearly 1/6th the investment return that could have been had. So what's happening here, there's a few things that are obvious such as cost. I think, and a lot of folks who are interested in investing and planning for the future aware of your taxes can be an obvious drag on performance. Cost of the internal investments is another factor. You need to look closely at and decide, is there actually value being delivered there? But this gap, it's really like a hidden cost. And what it's all about is investor behavior. And people, it turns out, are often kind of their own worst enemy, and we've known this for a long time. About 20 years ago, Nobel Prize was issued for studies in behavioral finance where they started codifying all these different common mistakes, ways people trip themselves up.

0:03:08.5 SO: But really, CJ, what's happening is, it's just an age-old issue of doing the opposite of what you should do in general. We know it's a basic principle investing, you wanna buy low and sell high. But there's a very natural tendency to the opposite, and it's chasing returns on the upside, it's blowing out during panics. And this can lead to a self-destructive cycle of buying assets when they're expensive, selling them at a loss. And then really, unfortunately, often missing the gains in the market rebound, and not entering again until things are expensive. We had a number of calls a year and a half ago when things were very panicky in the market, and spent a lot of time talking about this exact issue and the dangers of selling out. So it's a challenging one, it's an age-old problem, but I think there are some steps people can take.

0:04:00.1 CJ: Can we hear about some of those?

0:04:02.0 SO: There are three big steps I'd encourage people to start thinking about. And that's studying market and financial history, broadening your vision, and then following some rules. And so what I'm talking about here in relation to this, the pitfalls of this behavior gap, I find tremendous power in studying market and financial history. And if you look at the long term, you look at what's happened, you come to realize that, first of all, capturing the market's return is very powerful over time. And also that's very hard to outperform it with market timing moves, very easy to underperform it. So you can see that by looking at the pattern of market returns. And if you look at performance of different investments versus the Benchmark Index, you'll say, "Hey, just capturing the investment return would be a great thing over 10, 20, 30 years," at least it has been historically. And what I don't wanna do is make a bunch of moves that keep me from capturing that return.

0:05:01.0 SO: So state of this history will show you the boom and bust and recovery cycles. It can help armor you up against the news cycle and all the various sources citing, "What's hot now," that really just kind of spread panic and doom during downturns and euphoria, and that feeling of missing out that we've been talking about on the up. So study market history and financial history, I think is very powerful in terms of forming your perspective and your decision making. The number two step, broadening your vision. Focus on your entire portfolio first rather than the individual slices. Eat that balanced meal rather than grabbing little Halloween treats for little sugar rush here and there.

0:05:46.1 SO: In that Morning Star Mind the Gap study, what they found, it's interesting, when they looked at different investment categories, this gap is much smaller in funds and fund categories that are broad-based like asset allocation funds or balanced funds. People do comparatively better in those categories, because they're less volatile and they stay more on track with their goals, and they tend to just do a pretty good job over the long run. When you get into more specialty areas and sector funds, that gap gets much larger. People are going to use those as trading tools, they're in and out. They're trying to buy a single stock... Single company stock fund when that country looks like it's hot. And alternative funds were very poor. So some of these esoteric areas, in fact, they showed negative returns over the long haul versus what was actually delivered to the fund.

0:06:37.4 SO: So focus on a well-designed balanced portfolio suitable to your long term goals, and keep that as the primary focus rather than bits and pieces of these specialty areas. And then the third one, follow the rules. Develop a set of written guidelines for how you make portfolio decisions. The work of clients, we call this an investment policy statement, we integrate it with their overall financial plan. And it helps us decide, when times are calm, when we have clear minds, when it's not a state of panic, or feeling that missing out... Running the lifeboat drills beforehand to decide how we're gonna make decisions. It can help us during times of panic. It's like, "In case of emergency, break glass." Okay, let's go back to our written rules. How did we decide we're gonna think about money and make investment decisions? And that can help give yourself the advantage of a calmer mind when things are getting heated. So I think those three steps can help them.

0:07:41.3 CJ: Okay, so you're gonna have those on your website, correct?

0:07:46.7 SO: Yes. So all these discussions, CJ, WTIP, you've been recording them and putting them on your website. I also post them on my blog, which is www.scottoeth.com. And I'll put the transcript in there as well and a few supporting materials.

0:08:02.9 CJ: Alright. Can you talk a little bit about the new tax bill?

0:08:07.9 SO: Well, you know, I would be happy to, but we don't quite know where it's at. It's day-by-day, we're hearing bits and pieces. So there were a lot of proposals that were put up, and a lot of them seemed like pretty strong measures. And what's happening now is, through the legislative process, it seems like being stepped back on a number of those issues, so we're still waiting to see what actually comes out of it. I'd be happy to come back as soon as the ink is dry and we see where things are at, and we have a chance to hopefully quickly work through that and see if there are planning moves people should make before the end of the year. But it'll be interesting to see what comes out of it.

0:08:48.8 CJ: Alright, well, I see that in our future conversations.

0:08:52.3 SO: Yes. Thanks.

0:08:53.1 CJ: Alright.