Most individual investors are poor investment portfolio managers
Investors more easily understand investment costs that are directly measurable, such as fees deducted on investment statements. However, many investors ignore or are unaware of the “opportunity costs” of their sub-optimal investment behaviors. Opportunity costs are usually much more difficult to measure directly, but these investment costs can be even higher than more visible investment fees.
The opportunity cost of being poorly diversified can be quantified under certain circumstances. While sub-optimal diversification costs can be difficult or impossible to anticipate for individual portfolios, investors can look at studies of large investor populations for guidance on the size of investment opportunity costs. The study, “Equity Portfolio Diversification” by Alok Kumar of Cornell (now at U. Texas at Austin) and William Goetzmann of Yale is particularly useful in providing investors with an indication of the scale of the opportunity costs incurred by poorly diversified individual investors.1 (See also this related article about this study: Is the average individual investor portfolio well diversified?)
Professors Kumar and Goetzmann analyzed over 40,000 discount brokerage equity investment accounts with over $2 billion in total assets for the 1991 through 1996 period. The equities purchased by these investors tended to be in large consumer products and technology companies with well-known names – many of the same firms that constitute the S&P 500 index.
The vast majority of these individual investors’ portfolios were very significantly under-diversified.
On average, the portfolios of investors in this study held four stocks in 1991 and 7 in 1997. About 25% of accounts held only one stock, and about half held one or two stocks. On a risk-adjusted basis, this lack of diversification was quite costly to these investors. When compared to the broad market portfolio, 80% to 90% of these investors’ portfolios underperformed the market over the period of the study.
In a typical sample month, 83% of portfolios with only one to three stocks underperformed the market, while 72% of portfolios with seven or more stocks underperformed the market. Average portfolio performance overall was suboptimal, but when a portfolio was less diversified, performance was even worse.
While Professors Kumar and Goetzmann do not report specifically on the dollar impact of the suboptimal diversification strategies of these individual investors, it is possible to get a rough estimate of the opportunity cost to these investors. Professors Kumar and Goetzmann used statistical methods to compare the performance of the combined portfolio of all individual investor accounts with the performance of a widely used, “multi-factor” broad market returns model. The model estimated returns for a) the market in excess of the risk free rate, b) a large versus small stock factor, c) a value versus growth stock factor, and d) a performance reversion to the historical average factor.
Professors Kumar and Goetzmann provided a graph of ‘alpha’ comparing the returns of all individual investor portfolios combined to the S&P 500 index.2 Alpha is a measurement of portfolio performance that adjusts for risk. It is a commonly used measurement to compare the performance of a money manager in the professional money management industry to a relevant market index. Positive alpha would indicate performance in excess of the benchmark index, while negative alpha would indicate performance that lags the index. Positive alpha is not necessarily an indicator of investment still, but rather it could just be the artifact of lucky securities selection. (See: How stable have Morningstar Ratings been over time? and What the instability of mutual fund Morningstar Ratings means for long-term investors – a commentary)
The aggregate portfolio for all individual investor accounts in this study demonstrated negative alpha throughout the four-year study period.
When compared to the multi-factor market model, the aggregate portfolio of these self-directed investors lagged the market model’s performance in every month of the 48 month study period. Instead, these investors could have held a close approximation to the multi-factor market model by holding a selection of broadly diversified, low cost, passive index mutual funds.
The aggregate investor portfolio of this study underperformed the four-factor market model by between .5% to over 4% annually. During the four-year period that was modeled, the total underperformance totaled roughly 10%. Given that the sum of investor assets averaged about $2.18 million, these investors had an estimated opportunity cost of over $200 million in only four years!
Owning a poorly diversified of portfolio stocks was a very poor investment strategy for the average individual investor in this very large sample.
The average annual return of the typical investor in this study was reduced by about 2½ percent annually. For example, an average investor with a poorly diversified $100,000 account unnecessarily threw away approximately $2,500 annually or $10,000 over four years!
The information from this study is discouraging. Compared to investing with a passive, broad market index strategy, these individual investors paid several unnecessarily prices. Because they were not diversified, on average:
- They incurred higher portfolio risk. (Risk equals portfolio price volatility, which causes great unease and worry to most investors. Less volatility is better.)
- They lost money relative to the passive multifactor market index return
(This is particularly worrisome, because with efficient market pricing one would have expected only higher average volatility, but not lower average returns. Apparently, these investors also had suboptimal portfolio management practices in addition to being under-diversified. Perhaps this is due to behavioral errors by individuals, such as holding losers forever, while selling winners too soon. Most active professional fund managers avoid these errors, and passive index fund managers are not even tempted to make such errors.)
- They paid unnecessary transaction costs and higher taxes associated with these active management strategies.
- They simply wasted the time that they spent tracking companies, but did not achieve superior risk-adjusted returns. (See: The value and opportunity cost of your time)
There certainly would have been more skillful ways for these investors to self-manage their portfolios. The average investor in this study demonstrated negative skill. He lost money when compared to a market index investment.
This is strong evidence that the average individual investor simply does not know how to manage his or her own stock investment portfolio.
Individual investors need either to dramatically improve their personal skills or fire themselves and hire someone who can do a better job. However, when individual investors do hire professional managers, they still need to be very proactive about understanding performance and measuring the full range of costs and taxes.
1) Alok Kumarand William Goetzmann. “Equity Portfolio Diversification.” Yale International Center for Finance Working paper No.00-59, November 2002: 1-43
2) ibid, p. 30
Investment and debt repayment tradeoffs
Another area where individual investors make mistakes is in the decision on whether to accelerate the pay-off of mortgages and other debts. Accelerated debt repayment depends on:
- cash flow or assets for the increased payments
- debt interest rates after taxes
- potential alternative investment returns on money consumed in higher debt repayments
- personal risk concerns
If someone has two debts (a 5% fixed rate mortgage and a 12% fixed rate credit card) and has the money for higher payments, does it make sense to pay off either debt? The issue revolves around risk aversion, because debts paid are debts that no longer exist versus a long term potential investment return on a personal portfolio that is uncertain. If a person has done a reasonable job of determining risk aversion and selecting an appropriate portfolio to match personal risk tolerance, then the alternative investment use of the funds becomes the determining factor.
A person with a very low risk tolerance would tend to pay off the 12% credit card debt and maybe even pay down the 5% fixed rate mortgage more quickly. Obviously, they need the assets and cash flow or need to cut consumption to generate the funds. Very long-term returns to a 100% cash portfolio have been about 3.7% annually, which includes 3% inflation. For this investor, obviously they could never reasonably expect to earn a return in excess of the credit card debt, so paying it down more quickly makes sense.
After that, it is close to a toss up over whether to pay off the 5% fixed rate mortgage. This would depend on this investor’s personal tax situation, but mortgage interest rate deduction on federal and state income taxes could reduce the effective mortgage interest rate from 5% to 4% or even below. For this very conservative investor, it becomes a toss up, because both rates are the same. Does he pay down the mortgage more rapidly or keep the cash and earn about the same after taxes. The essential choice is becoming debt free more quickly or having greater cash flow. There are a lot of places in the web, such as www.credit.com, to find loan calculators that can help people make better personal loan payoff decisions.
Now, let us look at the other end of the investor risk tolerance spectrum, which is a highly risk tolerant person who might want to hold a portfolio that is 100% equities. (Note that this is relatively extreme, since the research indicates that holding at least a minority bond position in an equity heavy portfolio tends to improve expected risk-adjusted returns, i.e. dampen portfolio volatility over time.) Since the very long term historical returns to equities have been about 9.3%, the question is probably not whether to accelerate the mortgage payment. Even after taxes are considered the expected portfolio return significantly exceeds the after-tax mortgage interest rate.
However, the question of paying off the 12% credit card debt needs a quick look. Nevertheless, the fact that credit card interest is not tax deductible means that 12% is still 12%. Since that 12% interest rate exceeds any reasonable long term expectation for equity returns, this highly risk tolerance investor would still pay off his or her credit card debt more rapidly rather than keep those funds in the stock market.