The Four Horsemen

The original podcast on the Four Horsemen was updated to become Chapter 9 in 3D Retirement Income. What you are about to read is Chapter 9 in its entirety.

Chapter 9 – The Four Horsemen

In the last chapter, we saw that over thirty years, the annualized investment returns the average investor takes home have been about half of the investments the investor invests in. This disparity results in a real-world difference in the hundreds of thousands of dollars.

But we haven’t yet seen why that difference is so significant. I posited that it is our behavior that is responsible. Investments perform very well when left alone. Only when we insert an investor do the returns dwindle. We make four mistakes as investors costing us potentially millions of dollars over our lifetime. They are:

Chasing Returns – Changing your investment strategy often to try and capture the highest possible returns. The result is often the opposite.

Poor Diversification – There are two forms. Under-diversification: all your eggs in one basket. Over-diversification: your eggs in too many baskets.

Market Timing ­– Attempting to be in the market only when it is going up and getting out before it goes down.

Panic – A period of euphoric investment followed by selling your equities when they are down, turning a temporary decline into a permanent loss.

These four mistakes are responsible for most of our abysmal returns. We will cover them in-depth and give a couple of tips at the end for how you can avoid them. 

If the average equity investor had invested $100,000 thirty years ago, they would have ended up with $450,000. The S&P 500 would have turned that $100,000 into $2 million.

That is an equity investor. The returns aren’t bad because they invested heavily in cash, CDs, or bonds, which get lower long-term returns. They invested in equities, either directly or through mutual funds and exchange-traded funds. The equities did fine—great even! Any other equity index over that time would have returned similar results. For example, investing in a fund that tracked Wilshire 5000 index would have ended out at over $2.3m. It is not the investments.

It is the investors that performed poorly.

Now, few of us would call ourselves average, and even fewer would admit to being below average. But we cannot all be above average either. We do not belong to the fictional town of Lake Wobegon, where “all the children are above average.” Most of us are indeed average, plus or minus a standard deviation. But for now, let’s assume that you are 50% above average!

That means you would have gotten 7.5% annualized over thirty years, not the 5% that the average equity investor got. And over thirty years, you would have turned that $100,000 into almost $1 million. Okay, that is much better. But you are still short another $1 million-plus over what the indexes received. Even assuming your returns are 150% of your peers’ returns, these four mistakes still cost you wealth.

What are these mistakes? How are they this devastating? Let’s look at them in turn.

The First Horseman – Chasing Returns

The Grass is Always Greener in Another Investment

This Horseman is probably the most common and the hardest to avoid over a thirty- to sixty-year investing lifetime. Whether you are starting to fund your 401(k) for the first time with sixty years ahead of you, are entering retirement with only thirty years to go, or feel like your “long-term” may be only five years, without the two defenses you will fall for this one many times.

What is “chasing returns?”

Chasing returns occurs when you change your investments based on short-term investment track records or projections.

Short-Term Track Record

Have you ever done this? You are reviewing your 401(k) statement. You see your investments’ returns over the last one, three, five, and ten years. Then you see some of the returns of the other funds available to you, and some of them have been better than yours. You switch some of your funds to those with higher returns based on their recent track record.

Or perhaps you have a financial professional who has instructed you to move from this fund into that fund because it has been “outperforming” over the last x years.

Here is the problem with investing based on track record: There is no evidence of the persistence of performance.

A fund outperforming an index over a period does not mean it will continue going forward. If a fund has been performing over its trend-line returns, it may be more likely that it will soon dip below the trend line to maintain the average. Therefore, if you move money into a recently outperforming fund, the chances are good that you are doing so precisely before a period of underperformance.

It is like driving in stop-and-go traffic. You are stuck in the right lane during rush hour, and it is barely moving. However, the left lane seems to be moving fine. You flip on your signal and cut into the lane in front of a semi-truck. Then, the left lane pulls to a stop, and the lane you just left begins to move forward. You merge back over, behind a few vehicles that were behind you, only to have the lane stop again. Then the left lane takes off.

As you play the merge game, you try and identify a particular vehicle to see if you’re winning. “I was behind that pink truck, and now I’m ahead. Oh shoot, now I’m four cars back. Now more. I lost it. Okay, that van. That’s the one I’ll track now. And it’s gone. I should stop doing this.”

Before long, you realize you would have gone farther faster if you had simply stayed in one lane than continually trying to be in the fastest lane.

Chasing returns based on track record (Hey, that lane has been moving faster than my lane) is almost always a sure-fire way to get worse returns.

Projections

The other way we chase returns is not based on what has happened but on what we think will happen. Perhaps we’ve read an article from the Motley Fool, watched a few YouTube videos, or heard of an opportunity to catch the next wave. We move some of our investments into this new sector or fund or style in hopes of getting that higher return before it happens. We are chasing in advance instead of chasing in arrears.

Projecting returns seldom works. And the more often you try it, the more often you are wrong. It has been shown repeatedly that the vast majority of professionals, prognosticators, and pundits are wrong or will be so.

Harvard economist John Kenneth Galbraith said it well. “The only function of economic forecasting is to make astrology look respectable.”

You have as good a chance of investing based on your horoscope as you do based on the Motley Fool.

Investing based on predictions or headlines does not work. The people who publish these predictions have nothing to lose. If they are correct, they get some time in the sun. If they are wrong, so what. People won’t even remember their predictions.

But you will remember. You will be reminded by the terrible returns you got following their advice. Do not invest based on projections. It will not work out.

In the classic and often updated work, A Random Walk Down Wall Street, Burton Malkiel writes, “He who looks back at the predictions of stock market gurus dies of remorse.”

That doesn’t mean you should never change your investments. If you’re too heavy in fixed income or are in sectors that have always been bad, then you should establish a plan and change your investments to fit the plan. Make sure you are on the right road, changing lanes beyond that isn’t going to get you there any faster.

Chasing returns is probably the hardest to resist. Getting “average” returns just doesn’t seem right to us. Surely we are above average. And shouldn’t our returns reflect our superior status? We chase better ones. We are encouraged to chase returns all the time. Repeatedly, over sixty investing years, sources will pull us into chasing returns, only to lose out.

To be a successful investor, you must follow investment strategies for decades, not years.

The difficulty of sticking to one strategy for decades is why chasing returns is the First Horseman. It is number one in people succumbing to it. You can beat it, and we will get to that by the end of the book. Let’s first look at the rest of the horsemen.

The Second Horseman – Poor Diversification

All Your Eggs in One or Too Many Baskets

This Horseman comes wielding two swords of death to the investor: under-diversification and over-diversification.

Under-Diversification

You have heard that you should diversify your investments. Diversify, diversify, diversify. It’s excellent advice, and most people use it as a defense against this first sword: under-diversification.

The threat comes when we have all or most of our eggs in one basket. What happens when the nest falls out of the tree?

You see this a lot with the company stock of one’s employer when they have worked there for many years. Incentives have encouraged employees to own company stock, and over their careers, they have amassed a large portion. A large segment in company stock is hazardous because not only is their earned income tied to the company’s success, so is their life savings. The company going down will brutally destroy them.

You don’t think it can happen? Tell that to all the employees who worked for and had large stock positions in WorldCom, Enron, Circuit City, Compaq Computers, Blockbuster, and many more.

You also see under-diversification when someone bought into a company like Apple or Amazon when it was low, and now it makes up a significant holding. It has done so well that they can’t see themselves ever parting with or divesting any of it.

Under-diversification also happens when someone holds a disproportionate amount of money in one sector or style. Perhaps they have 80% of their money invested in the tech sector. This under-diversification devastated thousands during the tech bubble crash from 2000 to 2002. It wasn’t merely that they owned Dot Com companies that went bust. It is that they owned too much of them.

Do you have a lot of your money in one company or fund? How much is too much? Here’s what you should ask yourself:

Would you be financially okay if this company or specialty fund went to zero? Could you and your goals survive if you lost it all?

If the answer is “no,” you are under-diversified and need to spread out that money. Even if it means you may lose out on future “outperformance” by divesting some of your Amazon or company stock, you still must diversify and diversify before it’s too late.

“But I’m just going to hold on to it a little longer. I’ve been making a killing on it!”

Famous last words. Diversify, now!

As Nick Murray puts it: “Diversifying means you never own enough of something to make a killing on it or get killed by it.”

You may still be thinking that you have time. The company or sector has been doing so well! Everything else pales in comparison. Plus, there will be tax consequences if we capture the gains and other considerations. I need to think this through. I can’t just sell the position. Surely it isn’t that big of a deal. I’ve never been harmed before!

Under-diversification isn’t harmful until it is outright lethal. You will know when that happens, and it will be too late.

Over-Diversification

The other sword this Horseman wields is the opposite of the first. It is having too much diversification.

I see this a lot in my practice when reviewing a potential client’s statements. Their IRA will have eighteen different positions with no rhyme or reason for any of them. I’ll ask the client what the strategy is or the reason for all the positions.

If they picked it themselves, the answer is typically something to the effect of, “I just thought I should diversify it, so I picked a whole bunch of funds.”

If a financial representative recommended it, they will simply shrug their shoulders. “I have no idea.”

Perhaps out of their eighteen funds, they have most of their money in growth, large-cap, technology, and blue-chip funds. That sounds like good diversification, right?

We look under the hood and see that the top five holdings of all four funds are Apple, Microsoft, Google, Amazon, and Tesla. Oh, by the way, that is the same top five as the S&P 500 as of this writing.

It is pseudo-diversification. It looks good because you have a wide variety of funds and investments. In reality, you have a lot of the same companies in different packages.

Over-diversification brings two problems: Redundancy and Abandonment.

Over-diversified portfolios bring redundancy in holdings, increasing fees and bringing down overall returns on the same underlying companies.

Over-diversified portfolios also may increase the investor’s likelihood of abandoning the strategy because of Horseman One, Three, or Four. If you don’t understand why you have all these different funds and the strategy behind owning each and every one, you will not stick with them when facing another Horseman.

Beyond the cons, there is no good reason to have an overly diversified portfolio. It provides no benefit.

Examine your portfolios. Do you own enough of any one thing to be killed by it? Do you own so many things that you have no idea why they are there? The Second Horseman may kill you.

The Third Horseman – Market Timing

Lose by Not Winning

Market timing believes that you can be invested in the equity market only when it goes up and get out before it goes down. You “win by not losing.”

It feels like it should be possible. You look back at the markets and see these fantastic growth spurts followed by catastrophic crashes. Couldn’t it be possible to be in the market during a good market and then get out to preserve your gains? Even if you pulled out a little before the peak and didn’t get in right at the bottom of a dip, one should be able to sell high and buy low, right?

Market timing is not trading. Trading is daily, weekly, or exchanges of securities to try and make a profit between different funds or stocks. Market timing attempts to take advantage of market cycles.

The problem with market timing is that you must be right twice. When you get out of the market and when you get back in. If you’re wrong on either side, you’ll end up worse than if you have never tried. Let’s look at a couple of examples.

Bill was primarily invested in equity funds in the early 2010s. He never invested all his retirement in equities, but we’ll focus exclusively on his equity activity. Bill had a growing sense that a crash was coming. He acutely remembered the Global Financial Crisis, and was determined not to lose on the next drop. He paid close attention to the news and could read the writing on the wall.

The 2016 election was shaping up to be a nasty one. 2015 was flat, with some nasty volatility in the late summer. The market had peaked in 2000 before the Dot Com crash and then peaked again in 2007 before the Global Financial Crisis. It had been seven years since the last peak-before-crash. Bill’s investments were up more than 2 ½ times in that time. He decided to get out.

Bill sold all his equities in January 2016 and went to short-term bonds and cash to wait out the impending calamity. The 2016 election was brutal. And it did create some volatility in the market. But the crash didn’t happen in 2016. Still, Bill was convinced it was coming.

Bill had heard that you must be right twice. He knew he was right about when he got out. And he was determined to be principled about when he got back in. The previous market crashes had resulted in a 49% and 57% loss in the S&P 500. He knew it might not crash that far again, but he figured if it declined by 30%, then he would have a good buy. He waited for a 30% correction.

A correction happened in 2018, but it only dropped by about half of what he needed it to, and it didn’t trigger his purchase. The event finally happened in 2020. The Covid Crash dropped the markets swiftly. Bill put his money back in on April 1^st, close to the bottom and about 30% down from February’s peak.

He had done it! He had repurchased in at the bottom of a crash. His principle had been perfect. He would have never bought back in if he had waited for a 40 to 50% crash. But he knew he could make a profit at only 30% down. He had successfully timed the market. Or had he.

Between January 1^st, 2016, and April 1^st, 2020, the S&P 500 rose 56.5%. Bill did “get back in at the right time.” But he got out at the wrong time. If he had stayed invested, he would have had 56% more money on April 1^st—this after the 33% decline of the Covid Crash.

Bill pulled $400,000 out of equities in 2016 and put it back in 2020. If he had stayed in, he would have had $624,000. Bill’s attempt to beat the market cost him $224,000. But wait, it gets worse.

Compounding works better with more money. From April 1^st, 2020, through the end of 2021, the S&P 500 gained 70%. (Yes, some of that was recovery. The net gain from the previous peak was only 43%.) Bill’s $400,000 grew to $680,000. But if he had stayed in from 2016 through 2021, Bill would have had $1,063,000. The Third Horseman stole $383,000 from Bill, his family, and his legacy.

Let’s look at another example.

Todd waited longer before he got out of the market. He sold on January 1^st, 2020, after seeing reports of this scary new virus named after a beer. His move turned out to be prescient. The Covid Crash happened shortly after that. Todd perfectly timed getting out of the market.

The problem is that Todd didn’t get back in during the correction. It was a scary time. There were mass shutdowns, mask mandates, and hospitals were overflowing. Who wants to get into the market at a time like that?

Todd was surprised to see the market’s rapid recovery during a global pandemic. It caught up and pushed on to new heights and was leaving him behind! But he watched the news and heard many reports that it would be a “W” shaped recovery. Supposedly the market was in for another crash. Todd decided he would wait for the other shoe to drop and get back in then.

It never happened. Todd never got the chance to get back in lower than he got out. Between when he pulled his $700,000 out of the market in 2020 through 2021, the market went up nearly 44%. It would have taken Todd’s retirement account over $1 million, but he remained where he was. Even though Todd perfectly timed his exit, he missed his re-entry. The Third Horseman robbed Todd of $307,000.

We’ve seen what happens when you miss the timing of one side or another. You experience a theft of thousands. What happens if you miss both?

I met with a couple this past fall whom we were interviewing to see if they would be a good fit for our practice. They had moved $1.5 million out of equities in July 2018. Since then, the market has gone up almost 74%. They would have had $2.6 million. The Third Horseman stole over $1 million from them. They didn’t end up working with us and, as far as I know, they’re still trying to figure out when to get back in.

(I discuss timing the market in the thirty-seventh episode of the RetireMentorship podcast. In it, we examine a Tale of Three Brothers. One invests systematically throughout their life, regardless of the market cycles. One invests in chunks at the bottom of each market crash, perfectly timing the “buy low” strategy. The last is the opposite, only investing at the peak right before each crash. The results are fascinating. You can find that podcast at RetireMentorship.com/37.)

The Third Horseman is a deadly destroyer of retirements and legacies. Do not listen to the lies that suggest you can time the market.

In the immortal words of world-renowned fund manager Peter Lynch, “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in the corrections themselves.”

The Fourth Horseman – Panic

The Big Mistake

It’s one thing to get out of the market too early, miss out on gains, or neglect to get back in at the bottom and miss a recovery. It’s an entirely different story when you are in the market as it plummets. Especially when you are retired. You see your life savings falling by 20, 30, 40, or 50%. You cannot take it anymore. Not this. You panic.

Investors are often lured to their death at the hands of the Fourth Horseman’s siren song: euphoria.

The markets are going up and up and up—euphoria around investing sets in. The good times will never end! There is the excitement of being part of the “in” crowd. There is the joy of watching your money increase weekly, if not daily. It is alluring even for the most disciplined and principled investor.

Euphoria, sometimes called greed, is the phenomenon of buying an investment after and only after it has already gone up substantially in value. We see this with “New Era” and General Investing.

New Era Euphoria

We’ve seen a significant difference between investing and speculating. “New Era” investing is a subset of speculating, but it doesn’t always look like it in the moment.

“The times have changed,” people proclaim. “The old is lame. The new has come! It’s time to get on the train. Innovation is coming. It’s the New Era of [insert exciting new trend]!”

We saw this big time with the Dot Com bubble at the turn of the millennium. The internet was the New Era, and anything with a “.com” at the end was sure to be significant. All these new and exciting companies were steadily rising. People began to take notice.

“Look how great these stocks are! Look how impressive the returns are! How exciting! I want in!”

As more and more people began to buy in at higher and higher prices, it got more and more attention. This meant more and more people buying in at higher prices! As the prices continued to rise, so did the returns.

I heard of a client who sued her advisor because her portfolio had “only” gotten a 30% return in a year. Apparently, some of her friends had received an 80% return that year. (The trend line is 10%, right? Okay, I’m just checking.)

Friends. Does doubling your money in two and a half years sound too good to be true?

It is.

The euphoria of such returns was sucking in all kinds of investors. The disciplined ones that finally caved to the euphoria did the worst, finally buying in at the peak.

The bubble burst. The stocks plummeted, many to zero. The euphoric purchases were rewarded with tremendous permanent losses.

Euphoria. It’s enticing. And deadly.

We still see this today. We saw it with Bitcoin in 2017 and 2021. People buy in only after it has already gone up substantially. The only time I ever get asked by people whether they should buy Bitcoin is after it has already gone way up in price, beyond any reasonable level or at any reasonable speed. The pull of euphoria in the New Era is the siren song.

General Euphoria

Euphoria is not only for speculative investments. People fall for it in the general market as well. People want in when the broad equity markets have been going up for a while.

I’m not saying it’s bad to get into the market after it has gone up for a while. And I am certainly not saying you should get out after it has been up for a while before it comes back down.

But some people have stayed on the sideline year after year with money they could have invested but didn’t until the market was already high. That is euphoria. We saw it in 2006-2007. We saw it again in 2018-2019. People who had money on the sidelines since the bottom of 2009, asking if, now that the market had gone up for the last ten years, it was finally a good time to buy.

It also shows up when people believe that the market won’t go down. It’s been going up for so long; it must always go up! It’s 90 degrees in October, baby! The summer is never going to end! Let’s buy a boat!

They borrow money or invest their Blue Bucket into the equity market. They have nothing to fall back on when the market corrects.

Euphoria is the siren song, luring people to their death at the hands of the Fourth Horseman.

Death by Fear

The sunniest of summers are often followed by the whitest of winters.

Imagine you have worked for thirty to forty years. You have built up a modest but sufficient nest egg. It is your life savings. The market has been mainly good to you and has helped propel you to new heights. But now, as you approach or enter retirement, the market is beginning to slip. It is beginning to fall.

You watch your life savings decrease. You’ve lost $100,000. $200,000. $300,000 gone. You are watching your life’s work evaporate before your eyes.

A long and cold December stretches into a more frigid January, which breaks into a longer February. People doubt spring will ever come. The bad times will never end.

You begin to tell yourself, “Surely it is better to cut my losses and save what I have than for it all to go to zero. Something is better than nothing! I’ll wait until this crisis is over.”

You panic. You sell your investments and go to cash. In doing so, you relieve the pain of seeing your money disappear.

This move turns out to be devastating. You went to cash at what turns out to be the bottom. The market comes raging back! But you are still in cash! Now what? Do you get back in? There is talk of another downturn. Maybe we should wait until then! But it doesn’t happen.

The market recovers without you, turning a temporary decline into a permanent loss.

Panic is the rarest of the Four Horsemen. It is also the deadliest. You can invest perfectly for 29 out of 30 years. You can stick to a disciplined investment plan and avoid chasing returns. One could have sublime diversification, avoiding the pitfalls of over and under. You can abstain from attempting to get out of the market before a crash. And you can eschew all euphoric notions.

But if you succumb to the Fourth Horseman even once, it’s over.

It can be easy to judge those who panicked out of a market at the bottom. If you find yourself on your high white horse, looking down on those whom the dark horse has trampled, chances are high you have never been there yourself. You cannot speak until you see your life savings that you need to live on evaporating and have felt that fear. Those of you who have been there know what I am talking about.

People claim that this will never happen to them and that it doesn’t happen all that often in general. The facts disagree with that sentiment.

The equity markets fell by a third in thirty days during the Covid Crash. People sold at the bottom. The only way for the S&P 500 to fall from 31% down to 32% is because people want to sell at 31% down. People want to take a 31% loss. But there are no more people willing to buy at 31% off. The price falls to a 32% decline where someone finally offers to do the deal. And when no more people want to buy at 32% off and some still want to sell, the price falls again to 33% off.

The same was true in the Global Financial Crisis and during Dot Com. Peoplesell at the bottom of market crashes, and those people are predominantly those in or close to retirement. You may believe the chances of this happening to you are meager. At least recognize that the impact is deadly.

There is no way to recover from the Fourth Horseman. Avoid him at all costs.

The First Horseman: Chasing Returns. The grass is always greener in another investment. You continually switch investments, hoping to get superior returns, but earning inferior ones instead.

The Second Horseman: Poor Diversification. All your eggs in one or too many baskets. You are trying to make a killing on one investment only to be killed by it. Or you have many investments with no strategy and abandon them when confronting another Horseman.

The Third Horseman: Market Timing. You believe you can get out before a market crash and get back in when it is lower. But you must be right twice, and most people aren’t.

The Fourth Horseman: Panic. The siren song of Euphoria during market advances beckons you in only to be turned into fear when the market declines. You cannot bear to see your investments go any lower. Better to lose some than to lose all. You sell it all—permanent loss.

Other reasons contribute to poor investor returns, but these are responsible for most of our woes. The Four Horsemen signal the destruction of our potential, impact, and legacies.

How do we defend ourselves against these lethal mistakes?

We adopt the Seven Pillars of Investing Success.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are those of the people expressing them. Any performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be directly invested in.