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Taking Us for Fools

Jonathan Clements  |  December 1, 2018

IF THE STOCK market decline resumes, we’ll soon be reading articles about remorseful everyday investors bemoaning their earlier foolishness.

No doubt some folks have been foolish. Perhaps they’ve belatedly discovered that Amazon and Apple aren’t one-way tickets to wealth, that they aren’t the investment geniuses they imagined, or that they misjudged their courageousness and shouldn’t be 100% in stocks.

But mostly, I view these articles as patronizing garbage that propagate the myth that all amateur investors are clueless and all professionals are super-savvy. What’s the truth? It’s a lot messier than Wall Street would like you to believe. Consider four points:

1. Professionals have an incentive to disparage ordinary investors.

General Motors doesn’t dismiss drivers as hopelessly incompetent. McDonald’s doesn’t joke about obese, calorie-crazed customers. Cable channels don’t mock the viewing habits of their subscribers. But on Wall Street, belittling clients is considered fair game.

Why? It’s a storyline Wall Street loves. If it can persuade individuals that they’re foolish and best served by professionals peddling sophistication, the Street has itself a double win: It can charge investors for high-priced handholding—and it can sell them overly expensive, over-engineered financial products.

2. Professionals have shorter time horizons.

You’ll likely make good money If you hold a globally diversified stock portfolio for the next 10 years. Even if we get a recession in, say, 2020, the economy will soon start growing again, corporate profits will rise and share prices will follow suit.

Indeed, historically, there have been very few 10-year periods when stocks haven’t posted gains. The good news: Most of us have at least a 10-year time horizon. Even 65-year-olds should have plenty of time to ride out a market decline—and their heirs almost certainly do.

That brings us to an obvious question: If we can be reasonably confident that results will be decent over the next 10 years, why would anybody fret over the next 12 months? I can imagine three groups who potentially would be concerned.

First, there are those who have made the mistake of keeping money in stocks that they’ll need to spend soon. Second, there are those who have recently realized they’re uncomfortable investing so much in stocks.

Who’s the third group? That would be professional money managers. Unlike the typical amateur investor, you’ve got to imagine they’re extremely concerned about performance over the next 12 months—because their paycheck depends on it. I’m not saying the typical Wall Street professional has been selling shares in a panic for the past two months. But let’s face it: They, more than anybody, have an incentive to limit short-term losses by dumping stocks.

3. Professionals drive stock prices.

In terms of setting stock prices, it isn’t who owns stocks that matters. Instead, it’s who trades them—and professionals likely account for well over 90% of the stock market’s trading volume. High frequency trading alone accounts for about half of U.S. trading. Make no mistake: The U.S. stock market is down 6% from September’s all-time high because professionals are selling, not you and me.

To be sure, money managers and investment advisors could be dumping stocks because their clients are yanking their accounts or asking them to dial down risk. But that raises the question: If these folks consider themselves savvy professionals, how could they possibly have allowed their clients to invest in a way that clearly doesn’t suit their risk tolerance? That suggests these professionals are anything but.

4. Evidence of amateur incompetence isn’t conclusive.

We are in the 10th year of the current bull market. But as I noted in a blog earlier this year, there’s scant evidence of investor euphoria. Margin debt—often taken as a sign of overconfidence among individual investors—rose just 0.8% in 2018 through September, when the market peaked. Mutual fund investors pulled $191.3 billion out of U.S. stock funds in this year’s first 10 months—hardly a sign of speculative fervor.

But what about the famous Dalbar study, which purports to show that mutual fund investors garner results that are so much worse than the market averages? That’s been trotted out for decades as proof that everyday investors are incompetent—despite the fact that the study’s methodology has been criticized by me in The Wall Street Journal (2004), the Finance Buff’s Harry Sit (2011), The Wall Street Journal’s Jason Zweig (2014), Michael Edesess et al (2014) and the American College’s Wade Pfau (2017), prompting some fiery responses from Dalbar.

And yet financial firms continue to publicize the Dalbar results. Why? Ladies and Gentlemen, kindly direct your attention to point No. 1.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include The View From HereA Little Perspective and Simple Isn’t Easy. Jonathan’s latest book: From Here to Financial Happiness.

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