by Ben Carlson, A Wealth of Common Sense
“There’s one good financial idea every decade or so, and 5 to 10 marketing ideas a week.” – Eugene Fama
The Vanguard Total World Stock Market Index Fund holds a little over 7,600 securities.
The Vanguard Total U.S. Bond Market Index Fund and Total International Bond Market Index Fund collectively hold over 12,400 securities.
As of the end of 2015, there were over 15,600 mutual funds, 11,000 hedge funds and 2,100 ETFs.
This group of funds include more than just stocks and bonds, but it’s pretty amazing that there are almost 50% more of these funds available than there are individual stocks and bonds.
The paradox of choice makes it extremely difficult for investors to wade through this sea of complexity, but it also increases the temptation to make changes to a portfolio. People have a hard time sitting still in the face of this sheer number of choices, even when there are proven benefits from inaction with your investments.
This past week the Wall Street Journal profiled Steven Edmundson and Ken Lambert, who oversee the $35 billion Nevada state pension fund. They keep things fairly simple in terms of their investments. They don’t have a huge staff or a large research budget. But they do have some of the best returns out of all pension funds over the past 1, 3, 5, 10 and 20 years because they understand the importance of inaction.
Some highlights from the story:
The Nevada system’s stocks and bonds are all in low-cost funds that mimic indexes. Mr. Edmundson may make one change to the portfolio a year.
“Doing nothing is harder than it looks,” says Ken Lambert, Mr. Edmundson’s predecessor and only outside investment-strategy consultant. Harder, he says, because of the restraint needed to practice inaction.
Even Mr. Edmundson can’t resist studying investment strategies. “I spend a lot of time researching things we ultimately don’t do.”
Plenty of pension funds would have much better performance if they practiced a similar low-cost, long-term approach. But that’s not the biggest takeaway here as far as I’m concerned. This goes beyond indexing or buy and hold. This has nothing to do with active vs. passive funds — it’s high activity vs. low activity.
This group still had to choose their asset allocation. They’ve had to make some changes to that allocation over time. But they’ve also decided that taking action for the sake of taking action is not a wise decision. This is harder than it sounds.
That dopamine hit we feel when we take a gamble and it pays off can be too intoxicating for some to ignore, so it can be more comfortable to make change after change. We have a really difficult time sitting on our hands and saying, “I don’t know” or “Let’s be patient and see what happens” in many situations.
Not only is there a wide range of investment products available but the markets are constantly tempting us to tinker and make wholesale changes in an effort to guess what will happen next.
In some ways, we should try to be more like rats or pigeons and understand our limitations in trying to recognize patterns where none exist. In his book, Your Money & Your Brain, Jason Zweig details a study that shows why:
In a typical experiment of this kind, researchers flash two lights, one green and one red, onto a screen. Four out of five times, it’s the green light that flashes; the other 20% of the time, the red light comes on. But the exact sequence is kept random. In guessing which light will flash next, the best strategy is simple to predict green every time, since you stand an 80% chance of being right. And that’s what rats or pigeons generally do when the experiments reward them with a crumb of food or correctly guessing what color the next flash of light will be.
Humans, however, tend to flunk this kind of experiment. Instead of just picking green all the time and locking in an 80% chance of being right, people will typically pick green four out of five times, quickly getting caught up in the game of trying to call when the next red flash will come up. On average, this misguided confidence leads people to pick the next flash accurately on only 68% of their tries. Stranger still, humans will persist in this behavior even when the researchers tell them explicitly — as you cannot do with a rat or pigeon — that the flashing light is random. And, while rodents and birds usually learn quite quickly how to maximize their score, people often perform worse the longer they try to figure it out.
Not only does human nature often force our hand by making it difficult to stand pat, but professional investors often make unnecessary changes to justify their fees, find comfort in the crowd, prove their intelligence or show clients that they’re doing something with their money.
When everyone around you is picking new stocks or funds and churning their portfolios by trying to guess where interest rates or corporate earnings are headed next it can feel lonely to stick with a more inactive approach.
I’m not saying you should never make portfolio changes or trades. It’s not about doing nothing for the sake of doing nothing; it’s about doing nothing in those times when it will most likely help you avoid making a huge mistake.
There needs to be a good reason for every move you make in your portfolio. Successful long-term investing is about learning to say no over and over again by developing a filter that helps you turn down more investment ideas than you accept.
Sources:
What Does Nevada’s $35 Billion Fund Manager Do All Day? Nothing (WSJ)
Your Money & Your Brain
Further Reading:
Doing Nothing is a Decision
Copyright © A Wealth of Common Sense
