Why do some investors consistently outperform their benchmarks, while others fail to do so? Contrary to popular belief, it has little to do with knowledge, skill or even luck. Rather, it’s behaviour.
Investors are often their own worst enemy. They may invest in the right assets, but they fail to capture the full performance of those assets because they make irrational errors, fall prey to biases and make misinformed assumptions. Better known as “chasing performance.”
This is less true of high-net-worth investors. No, the wealthy aren’t “perfect” when it comes to managing their money. However, HNW investors are consistently better at keeping dangerous investment behaviours and biases in check, and that is a key factor behind their better portfolio performance.
One of the most dangerous of all behaviours might be called “short-termism.” That’s a fitting way to describe a number of destructive actions: making decisions based on recent gains and losses, turning over positions based on current news, making “fast money” trades and speculations, and so on.
Short-termism is the financial epidemic of our age. Consider the bar chart below, which shows how long it takes to trade every single share of some of the biggest ETFs.
SPDR S&P 500 ETF is the largest, most liquid exchange-trade fund on the planet, offering broad exposure to the U.S. equity market – a classic “buy and hold” investment. But that doesn’t seem to be what investors are using it for: Its entire share count is traded in only seven days.
The table below shows the price of such trading. It compares the “buy and hold” performance of SPY to the dollar-weighted investor return.
(Dollar-weighted return tracks the size and timing of cash flows into the ETF, which shows what the actual investor experience is.)
I should point out that some of this performance gap can be explained by investors shorting the ETF, and by institutional investors using SPY as a “parking place” before allocating funds somewhere else. Still, such activity doesn’t explain the size of the difference.
Few HNW investors are “buy and hold forever” investors. But most are able to resist the call of this short-termism, which allows them to capture most of the performance of their assets. Here’s how:
They assume a three- to five-year hold period
HNW individuals generally assume a mid- to long-term hold (that is, three to five years at least) when they buy any investment. This is a product of the attention they give to long-term strategy and goal-setting: They’ve taken the time to understand why they’re buying, which gives them more confidence in what they buy.
This is particularly true of managed money: actively managed mutual funds and ETFs, hedge funds, private equity, etc. In general, HNW individuals judge the performance of these investments not over one or two quarters, but rather years, allowing them to properly assess the manager they’ve hired.
They control their speculations
True, some HNW investors are active speculators (although this group is smaller than many think). HNW investors speculate in a controlled, measured way that is more about taking calculated risks than capitalizing on short-term trading momentum.
When they do speculate, it’s usually in areas where they have a significant knowledge advantage. Even then, they limit these to a small portion of their portfolios. They separate speculations from core holdings, and routinely harvest profits to reduce risk.
They exercise selling discipline
Most of the HNW investors I’ve met have extraordinarily good selling discipline. They base their selling on rational reasons:
Business reasons: A deterioration in the underlying business changes the underlying investment thesis.
Valuation reasons: The investment reaches its full value, and it’s time to take profits.
Risk management reasons: The individual’s tolerance for risk changes, so an investment must be sold.
Personal reasons: The investor needs to use the money to accomplish a life goal.
Notice how none of these has anything to do with short-term events or market volatility. By establishing reasons beyond these factors, HNW investors are able to balance their desire for performance with a healthy dose of patience – call it the perfect cure for short-termism.
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