Asset Allocation Strategies

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>>> "The Big Secret Wall Street Will Never Tell You About Investing"


Motley Fool

By Mark Blank

Jul 5, 2022


https://www.fool.com/investing/2022/07/05/the-big-secret-wall-street-will-never-tell-you/


'KEY POINTS

* Fund-manager underperformance has more to do with compensation structure than it does with investing skill.

* Institutions are incentivized to pursue short-term gains, which leads to higher taxes.

* Retail investors can beat the market if they stay focused on owning great companies for many years."


"There have been numerous studies that suggest it is impossible to beat the market as an individual investor. Beating the market is described as so difficult, only the best and the brightest minds on Wall Street achieve it.

So, if that's the case, who are individual investors to think they can pull off the miraculous feat of outperforming the larger market? Ludicrous, right?

Perhaps. But before you write off investing in individual stocks, there are a few flaws in that argument you should consider that Wall Street doesn't want you to know.

"Professional incentives

Using professionals as a benchmark for individuals is problematic because institutions have unique incentives that drive their trading behavior. The two main motivators are investor retention and performance-based bonuses.

In other words, fund managers need to generate high returns every year because if they don't, they will likely lose investors and make significantly less money from their year-end bonus.

These are powerful motivators to pursue short-term gains. Meanwhile, individual investors have no pressure to produce immediate results.

High turnover among funds

Ironically, the conclusion investors should arrive at after hearing that over 90% of fund managers underperform the market is that chasing short-term gains is disastrous for long-term performance.

The main reason for this is high turnover. Turnover is the change in positions within a portfolio. At The Motley Fool, we advocate for low turnover, so your companies can compound on themselves over the long run.

In 2019, Morningstar found the average domestic stock fund had a turnover rate of 63%. Put another way, from the beginning of the year to the end, the average fund's holdings were 63% different.

Consequences of high turnover

As fund managers chase near-term results, there are very real long-term consequences for their performance. The two main costs are a lack of compound interest and higher taxes due to short-term capital gains.

Compound earnings is the byproduct of great investing, and it should be the goal of every individual investor. Compounding occurs when you start earning interest on your interest. If you earn a 10% return on a $1,000 investment, you'll earn more dollars each year as the overall portfolio increases. Compounding is hard to notice in the early years, but the results are dramatic after a few decades.

Very few fund managers ever get to enjoy this benefit because of the constant pressure to chase hot stocks. Therein lies a very real advantage for you as a retail investor: you're accountable to no one but yourself, and you face no outside pressure to chase hot stocks for near-term results.

Additionally, high turnover results in short-term capital gains taxes. These are the highest taxes you can pay on the sale of stocks. Unfortunately for fund managers, as they chase short-term results, they are frequently forced to sell stocks , resulting in higher taxes. These taxes eat into the fund's real returns, which is yet another advantage for long-term investors.

"Outperformance lies in patience

When you extrapolate why institutional investors underperform, what you learn is that overtrading is terrible for long-term performance.

Instead of throwing in the towel because the pros can't beat the market, you should conclude that you have a massive advantage by not having clients and year-end bonuses to impact your portfolio decisions.

And finally, whether it's the short-term nature of Wall Street's investing outlook or a general lack of optimism for new and disruptive companies, the financial media's track record of missed winners should only add to your conviction in your ability to...beat the market."

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