“By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals.”
— Warren Buffett, Berkshire Hathaway shareholder letter 1993
Most people invest for a very long time. The earlier you start the better. You should pay into a pension as soon as you start earning; better still, your parents will have paid into one for you while you were still at school. Most of us invest for all our working lives, but even when we reach retirement, most of us don’t suddenly stop investing in the stock market. Investing really is — or at least should be — a lifelong endeavour, and the best approach is a slow and steady one.
The problem is, human beings have a present bias. We are so focused on the here-and-now that it can be hard to see the big picture. We’re so finely attuned to what we perceive as short-term threats and opportunities that we lose sight of the fact that what really matters are the returns we receive over many decades of investing.
The industry accentuates present bias
The investing industry and the financial media only make this problem worse by focusing on very short timeframes. Fund performance, for example, is usually broken down into periods of one, three, five or ten years. We often read about how a fund has performed over even shorter periods — six or even three months, for example. But how a fund has performed over only a few months or years is almost irrelevant.
A new study shows just how misleading this emphasis on short-term data can be, and how the returns of investors who chase performance are substantially lower than the returns of investors who take it slow and steady. Three finance professors — Hendrik Bessembinder of Arizona State University, Michael Cooper of the University of Utah and Feng Zhang of Southern Methodist University — looked at the returns of more than 7,800 U.S. equity funds over the 30-year period to the end of 2020.
They compared the returns those funds delivered with those received by an investor simply buying and holding a fund tracking the S&P 500, an index of 500 leading publicly traded companies in the United States. The comparisons covered monthly, annual and ten-year periods, as well as each fund’s longest track record over the entire 30 years.
Outperformance decreases over time
What they found was that the percentage of funds that outperformed market benchmarks decreased with the horizon over which returns were measured. On average, only 46% of funds outperformed the total market over monthly horizons; 39% beat the market over 12-month periods; 34% over decade-long horizons; and a mere 24% for their full history. The researchers found that, for most funds, simply surviving, let alone outperforming, was a struggle; funds only remained in the dataset for an average of 11 years.
Their findings led Bessembinder, Cooper and Zhang to conclude that there is “a fundamental shortcoming of alpha (i.e. outperformance) estimated from short-horizon returns as a performance measure for a long-horizon investor”.
They added: “The results reported here imply that the evaluation of fund performance is intrinsically linked to return horizon: a given fund’s performance relative to benchmarks can be positive over short horizons and negative over long horizons, even when results are measured from a single dataset.”
So how can this be explained? Well, it’s because of what’s called positive skewness. The distribution of long-horizon buy-and-hold returns was strongly positively skewed; in other words, the bulk of the returns were driven by only a very small number of stocks. This skewness simply wasn’t observable in monthly returns, but it increased with the length of the horizon.
Two reasons for underperformance
The authors highlighted two main reasons why investors who use actively managed funds underperform investors who take the slow and steady route using indexing funds. The first is cost; investing in active funds incurs substantially higher fees and charges, which compound over time. The second reason for underperformance is a lack of discipline; in other words investors tend to buy and sell at the wrong time. The funds themselves returned an average of 7.7% a year annually over the three decades, after fees; fund investors, however, earned only 6.9% a year.
Overall, the study finds, investors sacrificed $1.02 trillion in wealth by investing in active funds instead of buying and holding a market-tracking S&P 500 index fund. That’s a staggeringly high figure, and bear in mind that it only refers to investors in the US.
Don't be misled by short-term data
As we’ve explained on this blog many times, beating the market over longer timeframes is very difficult. The finding that fewer and fewer funds outperform the longer the time period is perfectly consistent with ongoing analysis by Morningstar and S&P Dow Jones Indices.
In fact, both Morningstar’s Active/ Passive Barometer and S&P’s SPIVA scorecards suggest that the proportion of funds that outperform is much smaller than this latest study suggests. The difference, as the author and investment analyst Larry Swedroe has explained, is probably down to the fact that the performance data quoted by Bessembinder et al. aren’t adjusted for risk. On a properly cost-and risk-adjusted basis, fewer than 2% of funds outperform the relevant benchmark in the long term.
The key takeaway for investors is to beware being misled by short-term performance data. Remember, fund managers are inevitably focused on short-term figures, because that’s what drives their share price and determines their pay and bonuses. You, on the other hand, can afford to focus on the long term.
The slow and steady tortoise beats the hare
You're not in a hurry, so play the long game. Slow and steady wins the race.Warren Buffett was right 30 years ago and he’s still right today: by keeping costs low, and by staying disciplined and focused on the long term, ordinary investors really can outperform the majority of professionals.
PLEASE NOTE: The value of investments can go down in value as well as up, so you could get back less than you invest. It is therefore important that you understand the risks and commitments. This article is not personal advice based on your circumstances. So you can make informed decisions for yourself we aim to provide you with the best information, best service and best prices. If you are unsure about the suitability of an investment please contact us for advice.
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