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David Fulton is a Colorado Springs, CO fee-only financial planner providing Hourly and On-Going Financial Planning and Investment Management. While he works with a broad range of clients, David specializes in working with Active and Retired Military, Federal Employees, and Families with Special Needs Children.
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Financial institutions spend billions of dollars annually trying to gain a competitive advantage in the market place. The hot fund manager is rewarded handsomely as money pours into their investment accounts. The search for alpha, which measures the excess return fund managers earn above market risk, is a cutthroat endeavor. A fund manager who could consistently claim above average returns would be a superstar (hint, they can't). So what if I told you that women investors may know something about investing that most of the market doesn’t seem to practice?
According to a study from Fidelity Investments, women are actually superior investors than men. Now don't get overly worked up by the sensationlism of the title. We are talking about general trends across large groups of people. Investing is an individual endeavor, and investors come in all types. However, I do think it worth looking at the overall trends and seeing why it is women generally have over performed in two key variables; investment returns and savings rate.
According to the Fidelity study, women as a group tend to outperform men as a whole when it comes to generating a return on their investments. On average, the over performance consisted of 40 basis points, or 0.4 percent. While 40 basis points doesn’t seem like a lot, it can have a significant impact over time as gains continue to compound. 40 basis points is not insignificant.
Not only are women getting better returns, they are also winning the savings game as well. Fidelity's analysis also found in workplace retirement accounts women consistently saved a higher percentage of their paychecks than their male counterparts at every salary level. Women saved an annual average of 9 percent of their paychecks, compared to an average of 8.6 percent saved by their male counterparts.
Looking at accounts outside of workplace savings, such as IRAs and brokerage accounts, the data showed that in proportion to their account balances, women saved more in these accounts as well. Women added an average of 12.4 percent to their account balance, compared to 11.6 percent for men as a whole.
Hyperbole aside, it is worth looking at why women are over performing their male counterparts. University of California-Berkeley behavior economics professor Terance Odean and his partner Brad Barber from University of California-Davis have spent much of their career studying this phenomenon.
Why Women Have Over performed.
Odean and Barber study in the field of behavioral finance, which blends components of neurology, psychology, and economics. The bulk of research in modern economics has been built on the notion that human beings are rational agents who attempt to maximize wealth while minimizing risk. Essentially rational agents make good choices that provide them the greatest utility. These rational agents carefully assess the risk and return of all possible investment options to arrive at an investment portfolio that suits their level of risk aversion.
Behavior finance postulates that contrary to classical economics, individual investors tend to be anything but the rational, self-interested, profit maximizers that most economists view them as. Rather humans, being irrational, often make decisions that are counter to their own best interests. A large body of empirical research suggests that real investors behave quite differently from investors in the classical models. Many individual investors hold under-diversified portfolios and many apparently trade actively, speculatively, and to their detriment.
Odean and Barber's study revealed that the first reason women have over performed their male counterparts is because of overconfidence in male investors. Psychological research demonstrates that, in areas such as finance, men are more confident than women. Men seem to be hardwired to expect success and to regard themselves as above average. Because men think they are above average, they overestimate their stock picking ability.
As a result, overconfidence leads to poor returns. This is because overconfident investors seemingly trade excessively. Rational investors trade only if the expected gains exceed the transactions costs incurred by making the trade. Overconfident investors on the other hand overestimate their information and may even trade when expected gains are negative. Odean and Barber surmise that men are more overconfident than women and thus will often trade more and as a result their performance is worse.
The Impact of the Crowd
Investors are often attracted to stocks because others want them. Recency Bias is one reason for this phenomenon. Recency Bias is where stock market participants evaluate their portfolio performance based on recent results or on their perspective of recent results and make incorrect conclusions that ultimately lead to incorrect decisions about how the stock market behaves.
The day after a stock ranks among top performers, two-thirds of all trades by individual investors are buys. We see it going up, and we see that others are buying, so we buy thinking we need to be in on the deal. Unfortunately, just because others are buying does not mean it is a wise purchase. Further exacerbating the issue, more often than not the stocks that investors sell outperform the ones they buy!
Odean and Barber analyzed the stock investments of 35,000 men and women from February 1991 through January 1997. As they hypothesized, men ended up trading 45 percent more than women. As a result, their high volume of trades ended up reducing men’s net returns by 2.65 percentage points a year as opposed to 1.72 percentage points for women. These differences are most pronounced between single men and single women. Fidelity’s study found similar results as Odean and Barber with men 35 percent more likely to make trades.
The reason excessive trading is so impactful is that many brokerage accounts charge a transaction fee each time an order to buy or sell a mutual fund or stock is placed. These fees often range from $9.95 per trade to over $50 per trade. If you are investing even small amounts of money, these fees add up quickly. Additionally, many financial advisors or brokerage firms charge commission on each purchase in the form of front end or tail end loads and fees. Trading fees eat away at the gains. Transaction costs are an unambiguous drag on the returns earned by individual investors. Overconfident, serial traders, pay these costs again and again.
Many savvy investors sell losing stocks to harvest tax losses, offset their capital gains, and blunt the overall effect of taxation on their portfolio. This is called tax loss harvesting and is something many financial advisors say they do for you. Logical as this is, few investors are actually willing to admit defeat and sell a losing investment even to harvest taxes. That was Odean and Barber's conclusion after analyzing 10,000 discount brokerage accounts over three years.
The disposition effect is an anomaly discovered in behavioral finance and reflected in Odean and Barbers studies. The disposition effect relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value. The exact opposite of what you are supposed to do in tax loss harvesting. While taxes clearly affect the trading of individual investors, the disposition effect tends to maximize, rather than minimize, an investor’s tax bill.
According to Odean and Barber, real investors are influenced by where they live and work. They tend to hold stocks of companies close to where they live and invest heavily in the stock of their employer. These behaviors lead to an investment portfolio that is improperly allocated and does not appropriately reduce risk.
Real investors are also influenced by the media and friends and family. They tend to buy, rather than sell stocks when those stocks are in the news. This attention-based buying can lead investors to trade too speculatively rather than buying in accordance to a synchronized purchasing plan.
The Problem With Investor Psychology
Odean and Barber sum up the problems with investor psychology:
"In theory, investors hold well-diversified portfolios and trade infrequently so as to minimize taxes and other investment costs. In practice, investors behave differently. They trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk, and many are unduly influenced by media and past experience. Individual investors who ignore the prescriptive advice to buy and hold low-fee, well-diversified portfolios, generally do so to their detriment."
Lessons We Can All Learn
So how do we capitalize on these studies? I think the evidence points to a couple of concrete steps all investors can take to increase their market returns, men or women.
Diversify with proper asset allocation.
The first is to practice proper asset allocation. We have all heard the adage of not putting all of your eggs in one basket. Those assets that produce the greatest returns also consequently have the most risk. Modern Portfolio Theory (MPT) teaches us to divide your investments among different kinds of asset classes to minimize risk and maximize returns. MPT is outside the scope of this blog post, however, the goal is to build an efficient portfolio using your goals, your investment time-frame, and your risk tolerance.
In this example, assume you are a 40-year-old investor who is investing in a retirement account that you will not need to touch for 25 years. To build an efficient portfolio you must first determine what percent of your portfolio should be in stocks and what percent should be in bonds. Your individual risk tolerance should ultimately inform this percentage. The more risk averse you are, the greater percentage of bonds you should hold.
If you are unfamiliar with how to determine your risk tolerance you can use a rule of thumb to get started. The general rule of thumb is to weight stocks and bonds appropriately by subtracting your age from 100 to determine what percent of stocks you should own. This is just a start point but will put you in the ballpark. Say you are 40 years old, according to the rule of thumb you should hold 60% stocks and 40% bonds (100-40).
Within the stock and bonds in your portfolio you would want to further diversify by asset class. Rick Ferri's Core 4 portfolio is a good place to start as an example of asset diversification. Using a portfolio of 60% stocks and 40% bonds this portfolio is broken down to create the following:
- Rick begins with 36% Vanguard Total Stock Market (VTSMX); this fund holds over 3600 individual stocks and includes almost all major classes of funds within the U.S. stock market.
- He then adds another 18% in the Total International Stock Market (VGTSX); this fund holds over 5500 international stocks and gives him exposure to foreign companies across all major classes of funds.
- His Bond holdings include 40% of the Total Bond Market Fund (VBMFX) which consists of over 6300 bonds!
- His last 6% he uses a Real Estate Investment Trust (REIT) fund such as the Vanguard REIT Index Fund (VGSIX). A REIT is similar to a mutual fund and consists of property holdings.
This is only an example of one way to properly diversify your asset allocation using Modern Portfolio Theory, and is a good place as any to start.
For investors who want to practice proper asset allocation, but don't want to manage the diversification and rebalancing required, a lifecycle fund can be a good place to start. Lifecycle funds will generally start more aggressive as you are younger. As you age, they will automatically transition from stocks to bonds, thereby reducing your risk as you get closer to retirement age.
The knock on lifecycle funds are that the fees and costs are often times much larger than the individual funds that make it up. Lifecycle funds also tend to be quite conservative and will increase the bond allocation and decrease the stock allocation quicker than you may want if you tend to have a higher risk tolerance. However,for those that don't enjoy investing, this can be a great way to practice MPT without doing much work.
Buy and Hold
The second strategy is to limit the number of trades you make and get out of the market timing game all together by simply practicing a buy and hold strategy. Buying over time and holding on to your fund shares can limit transaction costs and tax consequences. We don't know which way the market is heading and trying to guess is an impossibility. A buy and hold strategy acknowledges our limitations, and keeps you from having to generate fees and taxes by constantly trying to jump in and out of the market.
Rather than market timing, the use of routine and automatic investing such as dollar-cost-averaging is a smart play. Each month set a fixed amount to invest. That fixed amount will purchase shares at the then-current prices. As share prices decline, the fixed amount will purchase a higher number of shares. On the other hand, when stock prices increase, the fixed amount buys fewer shares. By following this method you don’t need to worry about investing at the top of the market or trying to determine when to get in or out of the market and thus avoid the urge to time the market. Rather, overtime you are averaging the number of shares you purchase. The highs and the lows are dampened with enough steady contributions.
Finally, don't sell your positions unless you are rebalancing your portfolio to realign the percent of stocks and bonds within your asset allocation. A properly allocated portfolio is prepared to weather the storm. If the market drops, think of it as an opportunity to purchase funds at a steep discount. We all like sales don't we?
We are all under saving. We know that only 55% of Americans are even investing in the stock market. The current savings rate is only 6.7 percent, and has historically been much lower. Most of us will never reach our goals by only saving 6.7 percent. Because we know that compound interest is the most important factor in achieving our financial goals we know we need to save early and often to take advantage of the power of compounding. Because we cannot control the market, we can only control two variables that ultimately determine how much we will have in our retirement accounts; spending and savings.
Our savings rate may be THE most important variable we can control. Our savings rate is inversely proportional to how much we spend. The more we spend, the less we can save, and vice versa. According to Fidelity, women investors tended to outperform in this metric as well saving at a higher 9 percent rate. We need to all follow their lead and work to increase our own savings rate. 9 percent is probably still not enough with the average family needing to generally save at least 15 percent of their income.
To save 15 percent we must first understand what it is we are spending. According to the Consumer Expenditure Survey from the Bureau of Labor Statistics (BLS) the two biggest areas we spend are on transportation and housing. If you can control those two major expenditures, you can free up significant money for savings.
So take a page from those awesome and saavy women investors out there. Save more, trade less, practice proper asset allocation, and stick to your plan to make the most of our savings and maximizing our returns.