Technology vs. Mr. Market Feel Free to Invest in Yourself

By George Morgan

Members of the older generation have experienced the increasing role that technology plays in our lives. Those of the younger generation don’t know life without it. Technology drives our cars, monitors our health and exercise, and keeps track of our wayward children. The local weather forecaster uses technology to prepare us for rainstorms in the summer and for snowstorms in the winter.

Technology’s role in the financial services industry has also been increasing over the years. For decades, money managers have used massive high-speed computers to collect the financial data of publicly traded companies and then parsed this information to predict stock prices. Computers are being called upon to monitor our investment portfolios through the increased use of robo accounts.

The difference between the use of technology in weather prediction and in stock market prediction is that it does a reasonable job on sunshine but a horrible job on our investments. Over the course of the past three decades, less than 1 percent of the actively managed mutual funds have outperformed the market.

To our tech-friendly minds, this result seems to make no sense. If we peel back the onion, we will discover that the fault lies not with the computers, but rather with Mr. Market and his accomplices. A partial answer to this conundrum lies in the simple fact that computers use logic to predict the actions of an emotional organism. Despite the protestations of some members of the financial services industry, many investment decisions are knee-jerk reactions to media headlines.

A broader answer to the underperformance question lies in the way that mutual funds are structured and regulated. The legal description of the way that a mutual fund operates is called a prospectus. Pick up the prospectus of any actively managed mutual fund, and you will find that there are many constraints placed upon their portfolio managers.

The initial headwind begins with the requirement that funds are restricted to a specific investment style. That is, they must choose to invest in a limited group of stocks or take a specific approach. For example, there are over 1,200 mutual funds that describe themselves as big cap funds. This means that they can only hold stocks that have a market cap in excess of $50 billion. If large companies falter and small companies soar, they are stuck in the underperforming sector.

A second headwind for mutual fund managers lies in the legal restrictions placed on the percentage of any individual stock that they can hold in their portfolio. Most mutual funds are restricted to around 7 percent of any one stock. Therefore, even if the money manager decides that stock XYZ is the greatest thing since sliced bread, once they hold 7 percent of XYZ in their portfolio, they must move on to the second greatest thing since sliced bread, and so on down the list.

Eventually, portfolio managers may be forced to buy stock that they don’t really find all that attractive, just because they’ve already reached the upper limit on the stocks they like.

Another performance detractor is that the most mutual funds promise their shareholders that they will always be close to fully invested. If the market reaches a point where the portfolio manager would prefer to be only 50 percent invested, or even as much as all cash, that is not an option.

Investors who buy mutual funds also sell them, which creates a drag on the funds’ performance. It is not unusual for mutual fund investors to sell their current mutual fund and chase shares of the latest hot mutual fund. This forces the portfolio manager to sell stock in order to raise cash to pay the departing investors. If the market is moving up rapidly at the time, a portfolio manager may have preferred not to sell, but they are not free to make that decision.

Last, but not least, is the cost of operating a mutual fund. Trading costs money. The more activity the fund manager engages in to enhance performance, the greater the trading costs. Because mutual funds are for-profit operations, these costs are passed on to the shareholders, reducing investment performance.

Does all of this mean that investors should never buy an actively managed mutual fund? No! You have to start by asking, “What am I trying to achieve?” Not all investors are interested in the newest, hottest, and latest investment. Some are more interested in stability and having somebody else manage their investments for them while they devote their time and energy to their grandkids. In fact, they might think of the money they spend on portfolio management as an investment in themselves.

Editor’s Note: George Morgan has five decades’ experience in all phases of the investment process. He is currently the Founder and Principal of Morgan Investor Education. His website is morganinvestoreducation.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.