Chapter One Lake Moneybegone If I can tell you where you got your shoes at, can I give you a shoeshine?" It was near the peak of the technology boom and business had never been better for the investment bank where I was working. Naturally, the director of our research department did what many executives in highly cyclical industries do when their companies are minting money: He decided to spend it like a drunken sailor. The company flew more than a hundred analysts from various countries in Europe and the Middle East by business class all the way to New Orleans for a long weekend full of speeches and "team-building" exercises. A lot of what happened that weekend is unprintable, and some of it is a little hard to remember. Still, despite acting like drunken sailors ourselves, we learned a few things. One of my inebriated colleagues, for example, discovered that in America, unlike England, police cars and taxis look really similar. We bailed him out the next morning, but weren't around to lend a helping hand to another Brit who took the toothless, elderly African American man up on his offer to identify where he bought his shoes. He certainly wasn't going to guess Marks & Spencer, was he? "You got your shoes right here on Bourbon Street!" A good sport and not about to be a pedant about the Queen's English or a dangling preposition, he chuckled and sat down for his shoeshine while the rest of the group kept walking toward the bar. When he was done, the man, not having mentioned the price ahead of time, asked for $25. Whether today or sixteen years ago, that's a lot of money for a bit of spit and polish. But as my colleague began to object, five very large men suddenly materialized and made sure he paid in full. I love making bets, and I especially love winning them, though I've never relied on linguistic ambiguity, much less the threat of violence, to do so. One way to avoid being the patsy in a wager is to consider how much information the other person has compared to you, and another is to recognize when one of you is being overconfident. Here's a case when those two would cancel each other out. Say I were to bet every person reading this who said they were above average at investing (studies show most of you would claim to be) to benchmark your returns in the same way that people do for their looks or driving ability. The latter two are pretty hard to quantify, but portfolio performance isn't. Many of you wouldn't take me up on it, so it might seem like I'd be setting myself up for a fall by betting against a self-selected group-only the crème de la crème, as it were. Except I wouldn't be. Studies, among them one by German finance professors Markus Glaser and Martin Weber, show that there's absolutely no connection between how well an investor actually has done and how well they think they have done. None, nada, zip. Or, as the Herren Professors put it in more scientific language (ideally recited in a thick Teutonic accent), "The correlation coefficient between return estimates and realized returns is not distinguishable from zero." That's pretty amazing. But if I wanted to do better than just break even-much better, in fact-I'd bet you instead on whether or not you keep up with the market return. In Glaser and Weber's study the investors surveyed estimated that on average they had made nearly 15 percent on an annualized basis over the four years in question. Their average performance actually was just 3.7 percent, and only about two out of ten managed to keep pace with the overall market. Another much longer-term study of U.S. investors is even starker. In April 2015, Dalbar, a firm that evaluates fund managers, released results on how American investors in mutual funds did over the past thirty years compared to the markets that those funds were supposed to track. As I said in the preface, people unfamiliar with these numbers often scoff in disbelief. A handful of other researchers have attempted to calculate this "performance gap" and come up with numbers in the same ballpark. So read them and weep: The "composite fund investor" earned an annualized 2.5 percent during those 30 years. That is just awful. It's less than inflation during that time. In other words, if a typical saver had a nice nest egg at the end of 30 years it was only because he or she salted away lots of his or her paychecks, not as the result of any real investment gains. And of course this is all before taxes. Over the same time frame, the main U.S. stock index, the Standard & Poor's 500, earned just over 11 percent a year, and the broadest bond index, the Barclays Aggregate, managed 7.4 percent. Trailing the market in a single year or even for a few years is nothing to panic about, but three decades is an entirely different matter. That great boon to your nest egg, compound interest, works insidiously in reverse too. Fear, greed, naïveté, bad advice, and even the cost of sound advice combine to whittle away the pot of money we should earn after a lifetime of saving relative to what we could have amassed. Add up the effect of all this behavior and you wind up somewhere I call Lake Moneybegone. Like Garrison Keillor's fictional town of Lake Wobegon where all the children are above average, nearly all investors are below average, and not by a little. But while that sounds bad, a gap expressed in percentage points is just too abstract to resonate with a typical saver. "You really have to tell them that they should be shocked," says Dalbar's founder, Lou Harvey. "They really need to translate that into 'can you put your kids through college, can you fund your retirement?'" The sums left on the table really are shocking. To consider a simplified example, let's say your great-uncle leaves you a $100,000 inheritance at age thirty-five but doesn't entirely trust your judgment. He forbids you to touch the principal or change how it's invested until you retire at age sixty-five. Being a frugal and conservative sort, he picks low-cost index funds comprised of 60 percent stocks and 40 percent bonds and they rebalance back to those percentages at the start of each year. Now, let's say your best friend receives a similar gift but is free to invest it as she sees fit, though also without withdrawing any principal. Your friend is a typical investor. Fast-forward to the day thirty years later when you both qualify for Medicare and your great-uncle's gift would be worth over $1.5 million before taxes-seven times the $215,000 your friend has accumulated. That seems like it should be mathematically impossible. How can an average investor be so far below the passive return of the market? Where does all the money she didn't earn wind up? Like I said before, not money heaven. That foregone income is earned by someone else. While the children in Keillor's fictional town can't really all be above average, there's no reason why the vast majority of investors can't be below it. That's because "average" and "market average" aren't the same thing. Subtract the costs of investing from all the wealth that stocks, bonds, and other investments churn out and you have what investors earned on average, but not what an average investor earned. The gap of several percentage points between that typical investor's return and what the market as a whole generates each year has to wind up somewhere. Multiply that shortfall by the $23 trillion or so that Americans have stashed in retirement accounts and you begin to understand that the eye-popping compensation on Wall Street isn't conjured out of thin air. They at least owe you a thank-you card. As financial types put it, investing is a zero-sum game. I compare it to a poker room in a casino where players' money gets redistributed. There's a reason I'm not using the example of a friendly neighborhood game of five-card stud. Unlike your buddy's basement, the casino is a business and takes a "rake," or a small cut, of every pot in order to pay the dealer, its overhead, and of course earn a profit. It's a slow but, over time, not insignificant drag on each player's returns that's analogous to the financial services industry's middleman role. Calling costs "death by a thousand cuts" is a little too dramatic, but the slow bleed can do a surprising amount of harm. A typical saver spends something like $170,000 in fees by the time they retire and gives up a fifth of their potential return. Can you imagine how people would react if, instead of paying that amount little by little and having to read about it in tiny letters buried in a quarterly statement most of us glance at briefly, we got presented with a bill for $170,000 at age sixty-five? It would make my colleague's shock at the $25 shoeshine pale in comparison. But pay it you do. For most investors, that isn't even the biggest impediment to keeping up with the market. Much like any poker game by the end of the evening, the chips from investing are redistributed in a very uneven way that winds up costing you more. You, the reader, are like the guy who has to keep checking his little card to see if a straight beats a flush and walks home shaking his head and vowing to get 'em next time. For typical stock fund investors alone, Dalbar calculates that poor timing-zigging when we should zag-costs a typical investor almost two percentage points a year. That's nearly twice what we lose to fees and adds up to hundreds of thousands of dollars over a lifetime of saving. Yeah, really. You can choose to be upset about that or you can look at it constructively. What sort of world would you rather live in-one in which nearly everyone earned a 3 percent return on their money and the average market return was also 3 percent, or one where most people earned 3 percent but the average return was 7 percent? Unless you're racked by envy, that's a no-brainer. In the 3 percent return world you'd have to be especially clever and active to earn something like 7 percent, perhaps doing so with the help of an expensive "expert" who would pocket some of that additional return and almost certainly by taking more risk. But in the real world the gap between 7 percent and 3 percent is a result of all the things you thought would get you ahead and backfired instead. There are few failures in life as significant, surprising, or persistent as that of the average investor who always seems to be running as fast as he can in the wrong direction. The residents of Lake Moneybegone do all sorts of supposedly smart things, take unnecessary and poorly understood risks, pay princely sums to allegedly clever people, and, instead of earning a decent passive return that can build a modest amount of savings during a working life into a respectable nest egg, wind up with a lot less. That's why I say there's a silver lining to the grossly uneven distribution of investment returns. The money you should and could be earning is out there, and a big part of grabbing more of it involves being cheap and lazy. It's really a wonder that I'm not as rich as Rockefeller. In all seriousness, though, if I do my job properly then I'll have convinced you by the time you finish reading this book that less is more when it comes to investing. Framing investing choices in terms of odds, I'll demonstrate that many of the actions we take in the belief that they'll give us an edge do the precise opposite. And even if we think we can earn a market return or something close to it, we do a poor job of estimating the very wide range of possible outcomes for our nest egg. If you have a realistic idea of what to expect, you can be prepared instead of getting blindsided. Hope is not a strategy. You'll also see that other things you perceive as risky or even foolhardy can increase your odds of earning a solid, long-run return. Sticking our necks out is hard for many of us at the best of times and especially so during turbulent ones, but doing so allows investors to turn the market's lemons into lemonade. On the other hand, many risks are unnecessary or even hidden. There are funds, products, and investment practices that tantalize us with the prospect of something for nothing. Please understand that there are no free lunches. Fortunately, though, there are some cheap lunches, and these, oddly, are less popular than inferior strategies that have patrons lining up around the block. A handful of proven techniques and principles have allowed savvy investors to eke out a bit of extra return above what "the market" has produced. Many require a fair bit of patience and sometimes even professional guidance. Finally, I'll explain why the best kind of expert to follow is almost always the cheapest one. Don't take that to an extreme, though. For some people, either because of their temperament or the fact that investing intimidates them, failing to find wise counsel is penny wise and pound foolish. Before I start doling out advice, you should get a better idea of what sort of investor you are. That's a two-part question: financial and emotional. Let's tackle the numbers first. I don't know you, so I can't say for certain that you live in Lake Moneybegone and, if you do, whether it's the rough part of town or the posh side. As Glaser and Weber showed, you probably don't know either. Look back carefully at your own financial history and get at least an approximate idea of how you've been doing and how much you've been paying in fees, commissions, and the like. Leave taxes out of it for now. These calculations aren't rocket science, but they can get complicated. Just ask the Beardstown Ladies. The mathematically challenged women from a small town in Illinois rose to national fame following their investment club's annualized return of 23 percent during America's late 1990s infatuation with stocks. They doled out both financial advice and cooking tips and the public ate it up. But anyone who read their first bestseller, The Beardstown Ladies' Common-Sense Investment Guide: How We Beat the Stock Market-and How You Can Too, should have spotted basic errors in calculating percentage returns. One journalist finally audited their brokerage records and discovered that they actually had lagged the market significantly. There was no word on whether the recipes worked. Excerpted from Heads I Win, Tails I Win: Why Smart Investors Fail and How to Tilt the Odds in Your Favour by Spencer Jakab All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.
