While perusing Seeking Alpha on Sunday, I noticed a Market Current tidbit that quoted New York Times columnist Jeff Sommer stating:
The dismal truth is that over the long run, the average investor is a woeful investor.
Sommer used a study by Dalbar that showed over the last 20 years through December, the average return of all investors in United States stock mutual funds was 4.25 percent, annualized. Over the same period, the benchmark Standard & Poor's 500-stock index returned an annualized 8.21 percent. That is not the only study that shows individual investors underperform the benchmarks; Brad Barber and Terrance Odean performed a study that also showed individual investors underperform the market averages.
I mentioned two studies, but there are more and they all have similar findings; individual investors, on average, underperform the market. The argument can be made, as Seeking Alpha member Chowder has, that for income investors, beating the averages is meaningless, for income investors, building income flow is the top priority. While I agree with this, I also know there are investors who are looking to build their pot of money into a bigger pot and are looking for capital gain. For those investors, beating the market average is important, only in that if they cannot beat the market average, they would then be better off putting their money in an S&P 500 fund (NYSEARCA:SPY) or other market tracking fund.
As I have previously mentioned, I have been investing for 41 years and I have made many mistakes, have learned from those mistakes and yet will still make similar mistakes. Yes, there have been times I stank as an investor. Investing is not easy, it requires a number of traits that the successful investors have, but most investors do not use them, because they are not natural human inclinations. I will share with you some of the reasons most individual investors fail and hopefully you can avoid some, or all of them.
We Follow the Herd - In my opinion, this is the number one reason most individual investors fail. One of the most common remarks I have heard from investors that have been out of the market for an extended period is "I got killed in the tech wreck!" For new investors not familiar with the "tech wreck," this describes the period in the 1990s and 2000 when technology investing approached the Dutch tulip bulb mania of the 1600s. Anything technology related had a high valuation, and yet many so called experts were writing and showing up on television telling everyone the valuations were not too high because this time, it was different. Well they were wrong, and in a very short period of time, technology stocks dropped like a rock. The heavily technology weighted NASDAQ hit an all-time high of 5,132.52 on March 10, 2000. Approximately one-year later on March 13, 2001, the NASDAQ was at 1,923.38, a drop of almost 62%.
Anytime anyone says this time is different, sell whatever you own in that sector. If everyone is investing in a sector and proclaiming how they are making easy money, sell. The crowd may push prices up for a short time, but eventually the day comes where everyone decides to leave the party at the same time, and that can be painful. By buying what everyone else is buying, you are very likely overpaying, and overpaying leads to diminished returns.
It is far better to buy what is currently unpopular than to buy what everyone else is buying. On March 2, 2009 you could have bought Wells Fargo (NYSE:WFC) for $8.61. Yes, I know banks were struggling, and everyone hated banks, but WFC was never in financial trouble and had limited exposure to the assets that were causing all the problems. I bought WFC on March 31, 2009 for $15.96 and sold it less than a month later, on April 22 for $20.02. Although that was a nice gain, what I really should have done is hold on for the long term. I had the courage to buy something that was hated, but lacked the courage to hold on to it.
When a sector is out of favor, like bank and housing stocks were in 2009, it is best to look for the best of breed stock in the sector. The best-managed companies will be the first to recover, because they are the best-run companies in the sector and have been sold due to their association to the unpopular sector, not because the business is failing. The first banking stocks to recover were WFC and JPMorgan Chase (NYSE:JPM), because they were the strongest and best companies. The weaker banks, like Citigroup (NYSE:C) and Bank of America (NYSE:BAC) are still struggling to overcome their issues.
In the current market, most sectors have had nice runs and very little looks cheap. This makes the work of a successful investor harder, because the herd is buying everything and driving prices higher. In this situation, going against the herd means waiting for a pullback, which will come at some point, or working extra hard to find the one stock that has been overlooked.
We Trade Too Much - I have written two articles on excessive trading, My Investment Advice - Do Nothing and Buffett Agrees - Doing Nothing is the Path to Investment Success. In each article, I detailed how buying and holding stocks leads to better returns. I used some examples from my investing history to show where if I had held a stock my returns would have been better. My investing history is littered with stocks I should have held, but sold, because I thought (mistakenly) I had an even better idea.
Terrance Odean a Professor of Finance at UC - Berkeley wrote a paper titled "Why do investors trade too much?" In the paper, he documented the results he found from a study of 66,465 households. What he found was that the 20 percent of investors who traded most actively earned an average annual return 5.5% less than that of the least active investors. The reason for the overtrading was overconfidence, the belief by the investor that they had a better idea; in most cases, they did not.
I have always maintained there are not that many great stocks to buy at any given moment. To find a stock that has a business that is performing well, not overpriced and has a sustainable product that will be needed into the future is difficult. When you find one, buy it and hold it, as the business progresses, so will your returns.
Johnson & Johnson (NYSE:JNJ) closed at $59.04 on January 2, 2009; three years later on January 3, 2012, it closed at $65.25 with a miniscule 10% gain over three years. Some investors may have grown inpatient and sold the stock during this period, confident they could find something better. There is a chance they may have found something better, but there is also the chance they may have bought something worse. During this time, JNJ had some product recalls that hurt the consumer side of the business. However, at no time during this period did JNJ stop being a leading drug/health care company and at no time did it stop raising the dividend. JNJ had a bump in the road, but it never left the road and was still a world class company. Investors who held and did not trade have seen the stock price leap to $78.51 (as of this writing), a gain of approximately 20% since January 2012 and 33% since January 2009. Add in the approximately 3% annual dividend that you would have received over the last four years, and you have a stock that has returned you 45% in just over four years. Patience has its rewards.
Periodically, when I review my portfolio, I remind myself why I bought the stock. Is the fundamental business reason I bought the stock still in place? Do I believe the stock is going to move higher? Has the dividend been growing, and what possible issue could derail the stock? After this review, I usually find that the stocks I own are still good long-term holds and my original thesis is still in place. If the stock does not meet one of the criteria, it becomes a candidate for sale, but only after further analysis.
We Are Not Diversified - I am not a believer in over-diversification. I currently own six stocks, and I am happy with that number. There are Seeking Alpha members who believe 20, 30, or even more stocks are needed for proper diversification. If that works for them, that is fine, but I know I will never own that many. However, I also know I will never own just one stock or just one or two sectors. Investors were hurt in the "tech wreck" because they were over weighted in technology. Many investors believed they had found an easy way to make money and put all their investable cash into technology shares. When technology dropped, those same investors took heavy losses. Had those investors had 10% of their investable funds in technology, the damage would not have been as bad.
I am also becoming increasingly convinced that it is best to have some country diversification. There are several ways an investor can accomplish this, international mutual funds, international ETFs, and foreign stocks are just a few ways to accomplish country diversification. I prefer to hold U.S. stocks with international exposure in my portfolio. In my portfolio, I own Coca-Cola (NYSE:KO), McDonald's (NYSE:MCD) Exxon Mobil (NYSE:XOM); all three of these companies get more earnings from foreign operations than they do in the United States. I also own Canadian National Railway (NYSE:CNI) a Canadian company with large U.S. operations, and Walgreen (WAG), a U.S. company expanding internationally. I believe this gives me significant international exposure and protects me against direct investment in foreign countries where the accounting standards may not be as strong as in the United Sates. The world is becoming one large trading community. Spreading your risk out internationally will lessen the chance of a portfolio collapse caused by a country specific problem.
Investing involves risk; a successful investor attempts to achieve maximum return with minimal risk. By diversifying the sectors and countries you invest in, you decrease the risk with little or no decrease in return.
We Dismiss the Power of Dividends - I have mentioned numerous times that I am convinced that dividends are instrumental in long-term portfolio success. I have mentioned multiple times the study Ned Davis Research conducted when he compared results between dividend paying stocks from 1972 to 2008 against stocks that did not pay dividends. His study showed that stocks that pay a dividend and annually increase that dividend returned 8.6% per year. Stocks that did not pay a dividend returned 0.2% a year. The S&P during that period returned 5.9%. I have also mentioned the study where Wharton finance professor, Jeremy Siegel looked at stock market returns from 1871 through 2003, a 132 year period, and found 97% of the total after inflation gains from stocks came from dividends, and only 3% came from capital gains.
I can also tell you that the old Philip Morris was the best performing American stock from 1925 to 2003, posting annual returns of 17% and that Altria (NYSE:MO) outperformed the S&P 500 from 2000 through 2011. Quite astonishing when you think about the government regulation, litigation and taxation issues the cigarette industry has had to battle. Those gains were accomplished by the power of compounding dividends.
For the period ending December 31, 2010, the S&P 500 Dividend Aristocrats outperformed the S&P 500 Index over the one-, three-, five-, 10-, 15-, and 20-year periods ended December 31, 2010.
In my personal portfolio, I have seen the power of dividends. I have seen how re-investing the quarterly dividends help to quickly build the portfolio. I have seen McDonald's yearly dividend grow from the $1.50 a share it was in 2008 when I bought the stock, to the $3.08 it is now. Heck, I do not know what else I can tell you to convince you that buying dividend paying stocks and holding them for the long term is a beautiful thing. Just do it!
We Lack Discipline - Famous entrepreneur and author Jim Rohn said
Discipline is the bridge between goals and accomplishment.
In investing, you have to have a plan; the discipline to stick to that plan is the bridge to your success. Sticking to the plan will at some point require discipline, the mental fortitude to stick to the plan when things may be going badly. Investors who stuck with stocks during 2008 through 2009 and maybe even bought more were rewarded for their discipline. Investors who were disciplined and stayed diversified during the 1990s were rewarded by avoiding the "tech wreck."
When you turn on the television and hear someone say high yield debt is the place to be, you cannot sell all your stocks and buy high yield debt. Because two weeks later someone is going to tell you that commodities is the place to be. You cannot succeed jumping from one investment plan to another. I know, because I did that early in my investing career. I tried buying sector mutual funds that were the hot sector of the moment. At different times I owned a technology fund, an emerging market fund, a natural resource fund, an energy fund and a real estate fund. Take my word for it, this did not work. By the time I figured out the current sector was no longer hot and another sector was now the place to be, I was selling one fund that was in a downturn and buying another one that had already had a nice run.
Thankfully I now have a plan, that plan is to buy stocks that have a strong balance sheet, a dominant business with some moat to limit competition, a growing dividend and a sustainable product. Once I find a company with those requirements, I wait for an opportune time to buy it and then hold it for as long as the business performs well.
The discipline in this plan comes in holding the stock with the above characteristics when it may not be performing well. In 2011, MCD returned approximately 30%, last year MCD had a poor year and fell approximately 12%, but not once did I think of selling, in fact, I bought more. There were articles that stated McDonald's was no longer the dominant restaurant chain, McDonald's had new management and was struggling with menu issues. I didn't care, because I knew MCD was still expanding, MCD had thousands of additional restaurants to build in China, the world population was growing creating more potential customers, and MCD was still growing the dividend, so no chance I was selling. So far this year, MCD has rallied 12%. When holding leading companies, you have to expect periods of flat performance; nothing goes straight up. Keep your eye on the business. If the business is performing well, the profits will grow and the stock price and dividend raises will follow.
Summary - Successful investing is difficult. Most investors fail. They make wild bets, and they trade too much. They exit the market during downturns and buy back in after big gains. They buy stocks that everyone else is buying. They do not think long term, and they think of dividends as something for retirees.
In my opinion, to succeed, an investor needs to think long term, embrace dividends, focus on the business, not the stock, resist the urge to trade and go against human nature and buy what others are selling. If you follow those principles, I am confident you will find long-term success.
Disclosure: I am long KO, MCD, KMI, XOM, WAG, CNI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.