Peter Lynch, who formerly managed the high-flying Fidelity Magellan Fund from 1977 to 1990, is a legendary investor. Under his management, the fund averaged an astounding annual return of 29%. It would seem all you had to do was ride along with Lynch and you would earn phenomenal returns. But that didn’t happen. According to Fidelity Investments, the average Magellan Fund investor lost money during Lynch’s tenure there. How does this happen?
That may be an extreme example of what plagues individual investors, but it is highly illustrative of investors’ behavioral challenges. According to Dalbar’s 2021 investor behavior study, the average equity fund investor underperformed the stock market (as represented by the S&P 500) by nearly 1.5% over 20 years through 2020. The annualized S&P 500 return during that time was 7.43%, while the average equity fund investor earned 5.96%. That is a significant performance gap that could be costing investors their financial future. What’s behind the gap, and what can investors do to overcome it?
Investors Bear Responsibility For Underperformance
Investor underperformance is often a result of poor investment decisions. The great investor Benjamin Graham once said, “The investor’s chief problem — and even his worst enemy — is likely to be himself.” Investors who don’t have a well-conceived investment plan or the conviction to stick with it tend to allow their emotions to dictate their decisions.
Instead of focusing on their objectives, they often follow the herd, selling in panic during a steep market decline or buying near market tops. They try to chase performance by buying “market winners” — stocks or mutual funds that are leading the market. Others try to time the market, thinking they can predict the market’s direction to buy low and sell high. All these investing behaviors are fraught with risk and can lead to poor outcomes.
That might explain the severe investor underperformance with the Magellan Fund. In achieving an average 29% annual return from 1977 to 1990, Lynch had exceptional years of overperformance and some years of underperformance. For instance, in 1980, the fund had a 70% return. The next year, he underperformed the sector. Investors who hopped on board as the fund was soaring in 1980 may have been disappointed with the fund’s performance in 1981, jumping ship to look for another “market winner.” In doing so, they would have locked in their losses. Had they stayed with the fund for another 10 years, they would have averaged more than a 25% return.
Market Timing Is Difficult And Costly
To understand the considerable cost of destructive investing behaviors, look at what investors who try to time the market are up against. According to Morningstar, to beat the S&P Index, you would need to make the right call on the market’s direction two out of three times. It also means you would have to make two right decisions each time — when to exit and then when to re-enter the market. That’s a near impossibility.
Morningstar calculates the actual cost of trying to time the market. Based on its data, investors who remained in the stock market between 1997 and 2017, for all 5,217 trading days, generated a compound annual return of 7.2%. If, by trading in and out of the market, you missed 10 of the best days of the market, your return would have plummeted to 3.5%. If you missed the 50 best days, you would have lost 4.5%. The challenge for market timers is that the most significant gains in the market tend to occur during or after a market correction.
Gaining Control Over Your Investment Performance
Investors can gain control over their investment performance with a more thoughtful and disciplined approach to investing following these critical tenets:
• Turn off the noise. Some news outlets appear to trade in hyperbole and fearmongering, because it sells advertising. A news story, while perhaps consequential at the moment, will generally not have any long-term impact on your long-term investment performance. So, just ignore the noise, and stick with your plan.
• Create a thoughtful investment strategy. Your investment strategy should be based on your long-term goals and your risk tolerance. When you quantify your goals, you can establish measurable benchmarks for your plan. I believe it’s more important to have an investment portfolio based on your plan’s benchmarks, rather than stock index benchmarks, which have little to do with achieving your goals.
• Invest in quality. Limiting your investing to high-quality, well-managed companies with strong balance sheets and market positions can help insulate your portfolio against extreme market volatility while hopefully providing compounding returns over time. While any stock can get caught up in the contagion of broad market declines, these companies tend to lead during market recoveries. The key is to look for great companies selling at great prices (often found after a market decline) and hold them for the long term.
• Cut investment costs. For long-term investors, fees and investment costs matter. A difference of one or two percentage points in total investment cost can be the difference in tens or hundreds of thousands of accumulated capital over the long term. Watch out for high management fees and portfolio turnover because they drive most investment costs.
• Focus on your strategy, not the market. The Dalbar study shows that investors who stay patient outperform those who don’t. The stock market may fluctuate, but your investment objectives shouldn’t. Another study found that investors with access to almost instantaneous investment updates underperformed those who had less frequent investment information. That’s because investors who ignore the daily, weekly or monthly fluctuations in their accounts are more likely to stay with their strategy and avoid costly behavioral investing mistakes.