Switching Lanes

In the opening scene of the movie "Office Space" the protagonist Peter is stuck in traffic on his way to work. He watches the cars in the lane next to him move forward as his lane remains at a standstill, so he quickly changes lanes just in time for the free flowing lane to come to a complete stop. He then watches the lane he just left start to move. Again, his frustration gets the better of him and he decides to change lanes quickly back to his original lane....of course just in time for that lane to stop moving again. To punctuate the situation, he notices an elderly woman using a walker and moving at a relatively slow pace, pass him on the side of the road. The point is, he would have been better off staying in his original lane the whole time.

About 5 months ago a friend asked me to help him allocate his 401k. Like most 401k's he had about 15 mutual funds to choose from and I examined each of them with him. Now, I am a subscriber to Modern Portfolio Theory and the Efficient Market Hypothesis, so I had some rhyme and reason behind which funds I selected. I favored the funds with the lowest expenses and tilted the portfolio toward small cap and value funds. I helped him setup automatic rebalancing every quarter, and told him that he would probably only need to reexamine his allocation about once a year.

After 3 months, my friend called me and told me that he had just sold two of the funds I had helped him select. We were in the middle of a down market and he saw that these two funds were down the most since he had put his allocation together with me. He said, "I had to stop the bleeding." This thinking sounds logical, but essentially my friend was behaving the same way as Peter in the traffic jam example above.

The problem was the difference in our perspectives. My friend was focused on the poor performance of his portfolio over the last few months, where I was focused on the expected performance of the asset classes in his portfolio over the next 30 years. Even though he had no intention of making any withdrawals from his 401k anytime soon, he felt like he had to do something.

What my friend needed to understand is that there are going to be times when different asset classes in his portfolio are down, and those are not the times to sell off those asset classes. Instead those are the times where he could actually buy more shares per dollar than he would have before. For example, let's say that you invest $100 a month into your 401k, and you allocate 10% of your portfolio to a fund that is selling for $1 a share. That means every month you buy 10 shares. Let's say that the fund falls in price to $0.5 a share. Now your $10 dollars a month will 20 shares while the price is down. If you take the long-term view that the $0.5 price per share is temporary, you should take advantage of the low price while it lasts and accumulate as many more shares than if the price had remained the same.

Switching lanes based on recent performance, whether the recent performance is up or down, is a method of selling low and buying high. Not the best strategy for growing wealth over time, but this is the mentality of many hare investors.

Staying in your lane, taking advantage of times asset classes are down and periodically rebalancing is a method to systematically buy low and sell high. This requires discipline, patience and forward thinking....very much a trait of tortoise investors.

Does the Tortoise Investor Really Win the Race?

Aesop's fable concerning the race between the tortoise and the hare had always sounded unrealistic to me. How could the hare lose, really? This begs the question: In the case of long-term investing, is it true that the tortoise investor will win the race? The empirical data overwhelmingly suggests the answer is, Yes, most of the time. The masses want to dismiss the fable with regard to investing. The tortoise is slow and conservative and boring and the hare is quick and nimble and more exciting, essentially exchanging a smart and safer strategy for one that is speculative and more risky. To examine some of the reasons why the tortoise wins, first we must define attributes of a tortoise investor versus a hare investor.

Most investors today are hares whether they know it or not, simply by the investment options they choose to accept in their portfolio. A hare investor's objective is to beat the market, like it is some invisible adversary. Hares believe the market is relatively inefficient, creating opportunities to capitalize on security mispricings. The tortoise investor believes the market is a friend and highly efficient, meaning information is free flowing and widely dispersed, so security mispricings are rare and difficult if not impossible to capitalize upon. Tortoises strive to efficiently and reliably accept the returns the market provides.

Hare investors are more likely to move in and out of the market depending on the most recent forecast. Some hares use sophisticated computer models to look at different market cycles and trends to make buy and sell decisions, but many hares succumb to emotions such as fear and greed when making buy and sell decisions. Tortoise investors think the recent past is a poor predictor of future results and buy and hold investments for the long-run, transacting as little as possible. They are more likely to make decisions free from the emotions of fear and greed, relying more on future investment performance over the next decades as opposed to the performance of the recent past.

The biggest reason the tortoise wins is due to costs. It simply costs much more to try and beat the market than it does to accept market returns. A March 9, 2008 article in the New York Times written by Mark Hulbert entitled "Can You Beat the Market? It’s a $100 Billion Question" cites a study conducted by Kenneth French, a finance professor at Dartmouth, which concluded that in 2007 American hares spent over $100 billion in the effort to produce market beating returns.

Many former hare investors have caught on to the idea that a tortoise strategy will ultimately provide the best chances for winning results. In the same article above, Professor French calculates the proportion of the aggregate market cap invested in index funds (a tortoise strategy) has more than doubled to 17.9% from 1986 to 2006.

If you are a hare investor or think you may be a hare investor, you might want to reconsider the odds against you when racing against us tortoises.