The Four Horsemen
We have met the enemy, and he is us. ~Walt Kelly
Welcome to RetireMentorship, Your Mentor To and Through Retirement. I am your host, Freeman Linde, Certified Financial Planner®.
Today we examine The Four Horsemen, the mistakes most responsible for our abysmal investor returns. That’s coming up on the RetireMentorship Podcast.
First, the RetireMentorship Two-Min Tune-In. The primary points of the podcast in two minutes.
In Episode 1, we saw that over thirty years, the investment returns the average investor takes home has 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. If you haven’t listened to episode one, go back and do so before picking it up here. You can find that at RetireMentorship.com/1.
But in that episode, we didn’t see why that difference is so significant. We are going to tackle that today. Here are the four mistakes we make as investors that are 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: all your eggs in too many baskets.
- Euphoria – Jumping on the latest trend or bandwagon investment and not getting out because you can’t resist the outrageous returns.
- Panic – Selling your equities when they are down, fearing they may continue to go down, only to miss their return up.
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. Settle in for this important episode of the RetireMentorship Podcast.
The Four Horsemen
In Episode 1, we saw that if the average equity investor had invested $100,000 30 years ago, they would have ended up with $450,000. We also saw that the S&P 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. 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.”
By definition, most of us are average, plus or minus a bit. I will devote an episode later in this season to the fallacy where we all believe we are all above average. But for now, let’s assume that you are 50% above average!
That means you would have gotten not the 5% that the average equity investor got, but 7.5%. 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 got. Even assuming your returns are 150% of your peers’ returns, these four mistakes are still costing you big time.
What are these mistakes? How are they this devastating? Let’s look at them in turn, and then at the end, we will look at the two defenses against them.
The First Horseman – Chasing Returns
The Grass is Always Greener in Different 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, or 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 record or projections.
Track Record
See if you have 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. So you switch some of your funds over into the funds that have had 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 certain amount of time does not mean it will continue going forward. It may be more likely that if a fund has been performing over its trendline returns, it will soon dip below the trendline 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 traffic. You are stuck in the right lane during rush hour. The left lane seems to be moving fine, however, so you merge. Then, the left lane pulls to a stop, and the lane you just left begins to move ahead. You merge back over, behind a few vehicles that were behind you, only to have the lane stop again. And 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. Aaaaand 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, or watched a few YouTube videos, or heard of an opportunity to catch the next wave. So 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 right, 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.
As Burton Malkiel wrote in A Random Walk Down Wall Street, “He who looks back at the predictions of stock market gurus dies or remorse.”
Chasing returns is probably the hardest to resist. Getting “average” returns just doesn’t seem fun to us. So 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. 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 at the end. 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 probably heard that you should diversify your investments. Diversify, diversify, diversify. It’s excellent advice, and most people are using it as a defense against this first sword: under-diversification.
The threat comes when we have all our eggs, or even too many of them, 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 for ten to thirty years. Incentives have been in place for employees to own company stock, and over their career, they have amassed a large portion. A large segment of 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 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 they can’t see themselves ever parting with it or divesting some of it.
Under-diversification also happens when someone simply holds a disproportionate amount of their 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 2000-2002. 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: If this company or specialty fund went to zero, would you be financially okay?
If the answer is “no,” then you are under-diversified and need to spread that money out more. 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.”
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 planning practice when we are reviewing a potential client’s statements. Their IRA will have eighteen different positions in it with no rhyme or reason for any of it. 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 it was recommended by a financial professional, they will simply shrug their shoulders. “I have no idea.”
Perhaps out of their eighteen funds, they have most of their money in a growth fund, a large-cap fund, a technology fund, and a blue-chip fund. That sounds like good diversification, right?
We look under the hoods and see that the top five holdings of ALL FOUR funds are Apple, Microsoft, Amazon, Google, and Facebook. Oh, by the way, that is the same top five as the S&P 500 as of this recording.
It is pseudo-diversification. It looks good, and that 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 what the strategy is 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? You may be killed by Horseman number two.
The Third Horseman – Euphoria
The Good Times Will Never End!
This Horseman is the ultimate wolf in sheep’s clothing, siren song, and masquerader rolled into one. It is the excitement of being part of the “in” crowd. It 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. There is a significant difference between investing and speculating. I’ll do a separate episode on that difference later this season. “New Era” investing is a subset of speculating.
“The times have changed. 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 big. 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 an advisor who got sued by a client because her portfolio with him had only gotten a 30% return in one year! Apparently, some of her friends had gotten 80% returns.
Friends. Does doubling your money in two and half years sound too good to be true?
It is.
The excitement, the euphoria of such returns were sucking in all kinds of investors. The disciplined ones that finally caved in to the euphoria did the worst, finally buying in at the peak.
The bubble burst. The stocks plummeted, some 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 at the end of 2017 and now again, as I’m writing this in January 2021. People are buying 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. The pull of euphoria in the New Era is the siren song.
General Investing. Euphoria is not only for speculative investments. People do it in the general market as well. When the broad equity markets have been going up for a while, people want in.
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.
Euphoria is the people who have stayed on the sideline year after year with money they could have invested but didn’t until the market was already high. 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, if it was finally a good time to buy.
It also shows up when people begin to believe that the market won’t go back 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 to invest or stash their emergency savings into the market. And they have nothing to fall back on when the market corrects.
Euphoria can be lethal. But nothing is as deadly as the Fourth Horseman.
The Fourth Horseman – Panic
The Bad Times Will Only Get Worse
The sunniest of summers are often followed by the whitest of winters.
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 mostly 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 somehow longer February. People doubt spring will ever come.
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, going to cash. At least the pain of seeing your money disappear has been relieved.
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! And how 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 continues back up without you, turning a temporary dip into a permanent loss.
Panic is the rarest of the Four Horsemen. It is also the most deadly. You can invest perfectly 29 out of 30 years. You can stick to a disciplined investment plan and avoid chasing returns. You can have sublime diversification, avoiding the pitfalls of over and under. 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 who have been trampled by the dark horse, chances are high you have never been there yourself. Until you see your life-savings that you need to live on today evaporating and have felt that fear, you cannot speak. Those of you who have been there know what I am talking about.
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 having many investments with no strategy and abandoning them when confronting another Horseman.
The Third Horseman – Euphoria. The good times will never end. These investments that have skyrocketed will undoubtedly continue to do so after I buy them. I’ll just stay in them a little longer… too late.
The Fourth Horseman – Panic. The bad times will only get worse. You cannot bear to see your investments go any lower. Better to lose some than to lose all. I’m out. Permanent loss.
Other reasons contribute to poor investor returns. But these four are responsible for most of our woes.
So how do we defend ourselves against these lethal mistakes?
We need two things: A Plan and a Partner.
You Need a Plan
A plan will establish the investments you need for the goals you own in the life you have left to live. A plan based on history, not headlines. A plan says, “It doesn’t matter what has happened in the near past. Nor does it matter what this pundit or that prognosticator says will happen in the near future. We do not chase returns. Your investments are perfectly suited to your goals on your timeline and have been historically the best chance you have of reaching those goals.” A plan helps you avoid chasing returns.
A plan will be perfectly diversified. It may keep you from making a killing on any one thing. But it will also keep you from being killed by it. It will make sure you understand the level of diversity you have and why. A plan is harder to abandon than a random assortment of funds.
A plan rejects euphoria. It will already be positioned to achieve your goals, and there is no need to risk it all in euphoric pursuits. It is easier to sail away from the siren song when you plan to reach the destination without her help.
A plan gives you something to fall back on when panic is at the door. A plan will not have let the equity crash harm you. The only way to lose is to succumb to panic. You will be fine until the market returns. Stay the course. Stick to the plan.
You Need a Partner
A plan will help you stick to a well-diversified investment plan and eschew euphoria and panic. And a partner will help you stick to the plan.
At some point, it will be your plan vs. the world of financial media and gurus screaming at you to abandon the plan and do this, that, or the other thing. Can you maintain belief in the plan? Can you stick with it? Or will you be the last holdout who finally caves to buy at the very top of the market or sells at the very bottom?
You need a partner to hold you to it—an empathetic and tough-loving coach to speak truth into your life.
“I know it seems like this would be a good investment strategy, but remember why we have the one we do have.”
“I know that seems like an exciting opportunity, but look at everything we could lose if we’re wrong?”
“I know it is scary right now. I’m scared too. I know it looks like the world is coming to an end. But remember, we have this part of the plan to protect us through it. I don’t know when it will be okay. No one does. But I believe that it will be okay. Because it always has been. Believe with me.”
If you do not have both, go now and get them as fast as you can.
If you are looking for a partner and don’t know where to start, or if you already have one, but you don’t feel like they have given you the plan you deserve, the next episode is for you. It will be the Five Questions to Ask Your Financial Advisor. Whether you already have a financial planner or are looking for a new one, ask them these questions. Get answers from a few planners and compare. Then you can have the best partner and the best plan for you.
If you have questions about this topic or any other topic, you can send an email to Questions@RetireMentorship.com. Or you can call us at 1-855-6-MENTOR (663-6867) and leave a voicemail. We will respond to you directly, and if we get the same question repeatedly, we’ll turn it into an episode.
Thanks for listening, and we will see you next week.
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 the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. RetireMentorship is not affiliated with any Registered Investment Advisor, Broker-Dealer, or other Financial Services Company.
