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Sep 17 2011

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Can Investors Be Too Smart For Their Own Good?





When I was studying physical education at university, I learned about something called the Inverted-U hypothesis. 

The suggestion was this:  in sports, an athlete needs a certain amount of anxiety to perform at an optimal level. 

Without that “stress” they go out onto the sports field with the ferocity of a marshmallow, and they generally get creamed.

Too much anxiety, however, causes athlete’s to choke on their own ambitions.  Rigor Mortis prematurely renders them as effective as the stereotypical zombie (even in movies, zombies can’t sprint).

Here it is below:

Relationship Between Arousal and Performance

 

The more I study investing, the more I think about the Inverted-U hypothesis. 




Replace “arousal” with “financial sophistication” and you’d have the same curve.

Let me explain:

Someone who doesn’t save money and who lives beyond their means–paying credit card interest on luxury items, for example– has a low level of financial sophistication.  Their financial performance would be like Ben Johnson’s sprinting ability…without the drugs….without the training…and without food.

But someone who pays off their credits card balances every month, saves money, and diversifies their investments in low cost index funds could be described as having a moderate level of financial sophistication—yet their investment performance would be close to the optimal level.

The vast majority of people, however, who base their investment decisions on the economy, or the availability of the next great exchange traded fund, or a supposedly superior back-tested model of portfolio allocation, usually slip down the Inverted U slide, hang on to its bottom edge, and trumpet how far they are ahead of the curve.

  Most of the smart people (and they usually are really smart) who let the economy and the next great idea influence their investment decisions generally perform poorly.  These folks often coin themselves as “sophisticated investors”.  But there’s rarely anything scintillating about their investment results.

This brings me to the simple Couch Potato concept that Scott Burns popularized in 1987.  With this strategy, an investor would have two holdings: a total stock market index (initially the S&P 500) and a bond market index.

Money would be split evenly between the two indexes, and at the end of the calendar year, the investor would rebalance the portfolio (if it gets out of alignment) to retain the 50/50 split between stocks and bonds.

It sounds simple, doesn’t it?

Too simple?

Most sophisticated investors would say so.

But remember: most sophisticated investors earn poor results.  Looking at Hedge Fund returns, after survivorship bias and backfill bias prove the point.  You can’t get much more sophisticated than a Hedge Fund.  But the vast majority of them lose to the total stock market index.  Even before accounting for their outrageous fees, there’s little evidence to suggest that the average hedge fund manager can outperform the market—especially in taxable accounts.

On the other hand, the investor who accepts a simple strategy, sticks to it, and spends the rest of her free time playing with her kids in the park, rather than following the next great investment strategy, can whip the pants off most of the world’s financial geniuses. 

It’s human nature, of course, to strive for improvement.  We’re wired to do that.  And in most areas of life, that’s a good thing.  But in the world of investing, it might not be.

Let’s have a look at the evolution of the Couch Potato for a moment.

Deemed unsophisticated, many people over the years have tried to improve on it by back-testing combinations of other low-cost investment products, and offering them as alternatives.

Scott Burns himself has offered a few of these models himself.

Don’t get me wrong.  These alterations are fabulous.  But they might not always outperform the simple couch potato portfolio, despite their back-tested success.  Let’s have a look at the model portfolios on the Assetbuilder website to see how they have performed during the past five years.   Unlike the couch potato portfolio (comprised of just two indexes) the below portfolios contain anywhere between three indexes (for the Margarita portfolio) to ten indexes, (for the Ten Speed Portfolio)

As of August 2011

 

3 Mth Period

1 Yr Annual

3 Yrs Annual

5 Yrs Annual

YTD Period

Since 09/2006

Annualized

STD Dev

Couch Potato

-2.39

15.63

4.23

4.68

4.08

4.68

11.16

Margarita

-5.36

14.07

2.70

3.46

0.45

3.46

14.76

Four Square

-3.07

13.41

3.80

4.38

2.84

4.38

12.84

Five fold

-3.97

14.51

4.39

4.14

3.48

4.14

15.79

Six Ways From Sunday

-5.20

17.10

3.55

4.66

2.96

4.66

16.69

Seven Value

-6.04

16.75

2.93

3.86

2.05

3.86

16.84

Seven Value 2

-6.93

16.83

2.82

3.57

0.91

3.57

17.62

Nine Emerging

-7.35

15.97

3.04

4.13

-0.20

4.13

18.68

10 Speed

-7.82

15.07

2.46

3.64

-1.07

3.64

19.04

Can you see which portfolio has the best 5 year track record? 

Currently, it’s the simple couch potato portfolio: 50% stock index, 50% bond index, rebalanced annually.  Have a look at its 3 month track record, its one year track record and its 3 year track record as well.  Not too shabby.

I think all of these portfolios are great, but as you can see, more sophisticated approaches aren’t always better.

I have no idea which of these portfolios will outperform the rest over the next 5, 10, or 20 years (and nobody else does either) but I do believe this:

Anyone adhering to one of these portfolios through thick and thin will be placing themselves near the top of that inverted-U column.

On the other hand, most people who follow the economy and try to get tricky with fancy investment strategies will underperform the vast majority of “unsophisticated investors”

If you can balance yourself on top of the Inverted U, you’ll be just fine.  Just don’t let the winds of change shift you from the perch.

 





About the author

andrew hallam

I'm a freelance finance writer, lucky enough to have been nominated as a finalist for two Canadian National Publishing Awards. I'm also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, a book explaining how I became a millionaire on a teacher's salary, while still in my 30s. Working to empower people financially, I'm available to motivate and inspire people on basic retirement planning and index investing. I'm happy to comment on your questions, first, please read the Terms of Use.

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11 comments

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  1. avatar
    The Wealthy Canadian

    Hey Andrew,

    Thanks for providing such an interesting historical account of the Couch Potato concept that Scott Burns popularized dating back over 20 years ago. To be honest, I was unaware of a lot of the details you've provided – great job.

    I think a 5-year track record of 4.68 is quite good and it's interesting how the mix is 50-50 between equity and bond market indexes.

    I think your post really hits home in a sense that the reality is that an investor should not be looking for the 'next home run' and try to beat the markets with the next great fund or stock. Instead, sticking with a plan for the long-term and seeing it through is what counts.

    1. avatar
      Andrew Hallam

      Hey TWC:

      The return itself isn't great, but of course, the economic climate wasn't stellar either. You're so right though: seeking the next great thing can be a hazardous venture!

  2. avatar
    Value Indexer

    This is a great reminder! I try to get a bit clever now and then but I also stay detached enough that I could lose access to my portfolio for 5 years and not be worried about how it's performing.

    Athletes and other top performers are often described as not having to think a lot and not letting anything distract them or break their confidence, which is a good description of a reliable investment strategy. If only people could practice more before investing for real they would better understand the cost of common mistakes.

    A lot of advice is aimed at pushing people from one side of the curve to the middle, which can make it harmful to those who are already in the right place. But this post is suitable if not essential for almost everyone :)

    1. avatar
      Andrew Hallam

      Hey Value Indexer!

      You're absolutely right when you say:

      "Athletes and other top performers are often described as not having to think a lot and not letting anything distract them or break their confidence"

      I think that athletes and investors have more in common than most people realize.

  3. avatar
    My Own Advsior

    Great stuff Andrew!

    I recall this theory. Very interesting one and nicely applied to investing practice/reality!

    A 5-year track record of 4.68 is not bad given "where we're at" in this market climate. If you took a longer investment window, I bet the returns would be higher, closer to 7% for a 50/50 portfolio.

    |I recall Warren Buffett, your buddy :), said if an investor can always get 7% returns on their investments, they are doing well.

    1. avatar
      Andrew Hallam

      Hey Mark,

      Over the long term (past 30 years) the 50:50 stock/bond portfolio rebalanced annually has actually generated returns slightly exceeding 10%. Not bad eh?

  4. avatar
    My Own Advisor

    Great stuff Andrew!

    (Sorry about the last comment, fast fingers in typing and made some typos to prompt the moderation!)

    I recall this theory. Very interesting one and nicely applied to investing practice/reality!

    A 5-year track record of 4.68 is not bad given "where we're at" in this market climate. If you took a longer investment window, I bet the returns would be higher, closer to 7% for a 50/50 portfolio.

    I recall Warren Buffett, your buddy :), said if an investor can always get 7% returns on their investments, they are doing well.

  5. avatar
    Art

    I have nothing against the Couch Potato portfolio but stocks have been decimated in recent years so of course the strategy with a higher allocation to bonds wins in the short term. When interest rates rise it will be different.

    1. avatar
      Andrew Hallam

      You're absolutely right Art. But you never can tell what formula will do better over the next decade. I guess the example I gave above shows that there are no guarantees.

      Interestingly, I gave a seminar to some Americans yesterday, showing them what a $10,000 investment in September 2001 would be worth today if it wasn't touched, and if it was invested in Vanguard's total stock market index fund, with dividends reinvested.

      It would be worth $16,000 ish, for a 60% increase.

      You're right: stocks haven't performed well over the past decade, but I wouldn't say that they have been decimated.

  6. avatar
    RobberBaron

    thanks for a reminder of the Inverted-U and it's application to anxiety and performance. Equally applicable in the classroom, for both teachers and students!

    But when it comes to portfolios, I wonder if you don't leave something out – or rather, somethings. There are any number of other "investments" (or, sometimes more properly terms "holdings") to consider.

    real property – your residence, rental properties, long-term development properties

    precious metals – silver coins being one simple form

    commodities…

    collectibles…

    Of course there are more options. and I'm not recommending anything in particular. Just wondering how you feel about these types of investments, in a general sort of way.

    1. avatar
      Andrew Hallam

      Hey Robber Baron,

      Of course, everybody is going to have a different view on this sort of thing, but here's mine, for what it's worth.

      Most people have huge investments in real estate with their homes, so I don't think they need real estate additions to their portfolio. It may smooth a portfolio's volatility overall, but over a long period of time, historically, it doesn't augment returns.

      As far as precious metals go, I might consider them when they have lost money for ages and ages. I don't buy what's popular, and I think it's a really bad idea for people to do that. And currently, precious metals are popular. When you mention gold and precious metals for a portfolio, and everyone laughs at you, then you're on to something. If I mentioned gold or precious metals in the mid 90s, everyone would have laughed at me. But of course, that would have been the time to buy….not now. I like the "laughter" benchmark.

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