Many retirement investors worry they should be trying to outsmart the markets, when they really should be focusing on their own actions and controlling their behavior. As Howard Marks, famous investor, commentator, and co-founder of Oaktree Capital, in one of his well-circulated memos for his clients put it: “Superior investors… have to be superior in some way…either by having more information, analyzing it better, or behaving differently.”
To be a superior investor, you must have an edge. For Marks, a professional fund manager, being a superior investor meant beating the markets. Retirement investors can consider themselves superior investors if they can achieve returns that are close to the market’s return, adjusted for how much risk they are taking. Research from sources such as Morningstar, Dalbar, and Vanguard has consistently shown that most individual investors underperform the markets by a wide margin.
Professional investor or not, of Mark’s three potential advantages, (informational, analytical, and behavioral) the only one that really counts for modern investing is having a behavioral edge. Investment information is readily available to everyone, instantaneously and free. Wall Street has thousands of very smart analysts (not to mention artificial intelligence) studying that information, so having an analytical edge is nearly impossible. But how do we act on information? What do we do with our portfolio when the market is melting down? Here, in the realm of action, we can exercise some autonomy and become better investors.
First, let’s address the information and analytic edges, and why they are not helpful for modern retirement investors. If you have an information advantage over other investors, you could certainly outperform the markets. For example, if you knew ahead of time that a company was going to announce that they had beaten earnings expectations for the quarter you could buy the stock ahead of the announcement and then sell it after the news becomes public and the stock had responded positively. But, in today’s interconnected media-centric world, economic and market information is dispensed and digested by the markets in real time. Any true information edge is illegal insider trading. If you are privy to the sort of market-moving information that would provide an edge, you are not allowed to trade on that information. Most investors don’t have access to that information anyway, so we can only speculate.
As for an analytical edge, good luck. To have this edge, you must not only obtain the correct information, but you must also analyze it better than your investment peers. Wall Street employs thousands of smart, well-educated analysts, using the best and latest technology to dissect every bit of data that is available. Everyone is looking for a way to get ahead. Most investors in the real world do not have the time, resources, or training to compete and search for an analytical edge.
Moreover, ample research shows that Wall Street professionals do not really achieve the analytical edge they seek (This article, by Eugene Fama and Kenneth French, for example). Professional mutual fund managers, with all the resources and talent at their disposal, fail to beat their market benchmarks with any regularity, especially after including their fees in the math. If they cannot find an analytical or informational edge, it is not worth pursuing.
That leaves us with Mark’s last point: we can seek a behavioral edge.
While we can’t control the markets and the economy, we can control how we behave. We can control how we structure our investment portfolio – basing our decisions not on an information edge or analytical edge, but on diversification and long-term track records. More importantly, we can control our decisions to buy, sell, and hold our portfolio.
Controlling our behavior in the face of lousy market is never easy. Investors tend to buy at the wrong time – when prices are high – and sell at the wrong time, when prices are low. When markets get rocky, we get scared. Carl Richards famously defined the difference between how the markets perform and how INVESTORS perform as the “Behavior Gap.” If you buy an index fund and leave it alone, your return should be the market return, minus the relatively small internal expenses that the fund takes to operate. Morningstar’s “Mind the Gap” research shows that investor returns consistently lag fund returns by roughly 1–2% annually due to poorly timed purchase and sale decisions. Even if that research overstates the problem, small behavior gaps add up to big money over a lifetime of investing. As one of my favorite investment commentators, Paul Merriman, pointed out in various articles, books, and interviews, gaining ½% – 1% investment return per year can equate to millions over the lifetime of a retirement investor.
In the absence of better information and better analytics, closing that gap is the only way to become a superior investor. Your performance is not about choosing stocks, or timing the market’s rise and fall, but instead about discipline. Focus on your own behavior. Create a sound investment plan that serves your financial goals and that is based on long-term, historical data. Then stay with that plan.
What constitutes a behavioral edge? The behavioral investment edge lies in all the little actions – the daily decisions that we make that derail our financial plans. The most obvious is selling when the markets are falling and buying when the markets are rising. The ability to do so relies on another behavioral edge: keeping enough cash and safe investments on hand to avoid touching volatile investments at the wrong time and allowing them to recover. This requires spending discipline, but also the ability to accept a lower return on cash when markets are good, avoiding the temptation to take on more risk with that money at the wrong time.
But the edge can also be found by avoiding impatience with investments that do not seem to be performing, in not stopping retirement contributions in bad markets, and avoiding changing strategies based on what funds in your 401k did well last quarter, or what your buddy said they are doing in their portfolio.
Often, having the behavioral edge will feel wrong and scary – when it comes to investing, the more uncomfortable you feel, the more likely you are to be right. It means tuning out the news, carrying on with your investment plan when it seems like the world, or at least the market, is on fire. It feels naïve and lonely – when everyone else is selling, our innate instinct as social animals is to join the rush.
Although having a behavioral edge may be uncomfortable, there is a silver lining: being a superior investor does not mean mastering complex investment strategies, having a nose for undiscovered companies or technologies. There is no secret you need to decode. Becoming a superior retirement investor comes from inside us and is within our control — and that is where the work begins.
