Nearly everybody has jumped in their car, driven down their driveway and thought ‘Hmmm, the car’s feeling a little sluggish today’, only to look down and realise that they are driving with their hand brake on. Have you done this?
I know I have…I always feel a little silly… The volume on my radio turns off and my car starts beeping at me!
What’s the purpose of a handbrake?
To ensure a vehicle doesn’t roll down a hill and crash into something – it’s a risk mitigation device – and yes occasionally we accidentally drive with it on.
But would you knowingly drive with your handbrake on ALL THE TIME?
No…of course not…that’d be silly…you’d never get to where you wanted to go on time…not to mention all the fuel you’d waste and the potential damage to your car.
But believe it or not, that very same concept of driving with the handbrake on ALL THE TIME is rampant in the managed funds industry…and that includes where the vast majority of workers’ investment funds are invested – in Balanced industry and retail superannuation funds in Australia and 401K funds and Target Date Funds in the U.S.
So, what am I getting at here?
The main risk mitigation strategy these funds use is called “Diversification”. Its main purpose is to reduce the risk of an investing accident, such as the stock market rolling down a steep 30 to 60% decline.
Now such a risk mitigation device is perfectly legitimate if you’re just about to retire. Or as you’re about to “park the car” so to speak.
But it’s definitely not a smart risk management strategy for investors who are 10, 20, 30 or 40 years away from when they retire.
Imagine that…planning a very long road trip…which is really what long-term investing is all about…and trying to complete the entire journey with the handbrake on. Sounds pretty silly doesn’t it?
You see, the way diversification works in Balanced Funds is that capital is spread over many different asset classes such as stocks, bonds, cash, property, private equity, listed and unlisted assets just to name a few…to reduce the risk across the portfolio.
The idea being that if one asset class performs poorly, it will be offset by assets that might perform better, thereby smoothing out the bumps on the journey.
It does this by trying to reduce the size of the down movements of a portfolio of assets… but in doing so diversification across multiple asset classes also massively reduces the size of up movements.
Research over the years shows clearly that over-diversification stunts the up movements by a far greater amount than it reduces the down movements, over the long term.
This results in much much lower returns than are easily accessible from another type of fund called an index Exchange Traded Fund, which also has much lower fees.
You can actually see the huge effect of “driving with the handbrake on” in the Big Picture chart compiled by CRSP – the Centre for Research in Security Prices – dating all the way back to 1926. Just Google “Big Picture CRSP” to see for yourself.
Notice how far Balanced funds, the middle green line, lag behind normal stock market returns, the top blue line, which are accessible via Index Exchange Traded Funds.
Over the last 40 years, the stock market index is 83% better than Balanced Funds! All due to Balanced Funds driving with the handbrake on, all the time.
But that doesn’t include the tyranny of the compounded cost of the Balanced fund fees being paid year after year. Deduct these at 1.5% compared to 0.1% for an index ETF and the outperformance becomes 206% or 3 times more money!
Share Wealth Systems helps investors who understand that if they want to be better…they have to do it differently.