One of the investment lessons I have learned over the past few years has been how hard it is to predict what will happen next in the financial markets.  I was already on the side of markets being largely unpredictable in the short run, and I came away from the experience even more convinced.  To wit, here is a fun exercise.  

Imagine it’s the beginning of March 2020.  News outlets have not yet begun to report on the few dozen initial COVID cases popping up across the country.  However, you have knowledge about how the pandemic will unfold and completely upend the global economy.  You can use that knowledge to forecast the relative performance of stocks over the next few years.  Would you pick the companies that enabled us to shop, entertain ourselves, and work from the comfort of our own homes?

Surprisingly, from early March 2020 through the end of last year, many of the “stay at home” stocks dramatically underperformed their physical-world counterparts.  The following are cumulative returns over this period:

• Retail: Amazon -10.82%, Costco +70.10%, Simon Property Group (the nation’s largest mall operator) +11.79%.
• Fitness: Peloton -70.25%, Planet Fitness (operator of a national chain of gyms) +16.76%.
• Home Entertainment vs. Travel: Netflix -20.09%, Marriott International +20.81%.
• Dining: DoorDash -74.24%, Darden Restaurants (owns restaurant chains such as Olive Garden, Longhorn Steakhouse, and The Capital Grille) +50.98%.
• Music Streaming vs. Concert Venues: Spotify -42.42%, LiveNation Entertainment +14.76%.
• Work from Home vs. Work in the Office: Zoom Video Communications -35.49%, Boston Properties (nation’s largest office real estate investment trust) -40.58%.

OK, let’s call that last one a draw.

Minding the Gap

The assumption that markets are even somewhat predictable can get investors in trouble.  Failed attempts at market timing as well as performance chasing are two investor mistakes that stem from this assumption and detract from returns.  A study performed by investment data provider Morningstar sheds light on how costly these mistakes can be.

Morningstar’s “Mind the Gap” study quantifies the difference between the performance of U.S. mutual funds and the return earned by the investors in those very same funds.  On average, Morningstar finds that fund investors underperform the funds in which they are invested by roughly one percent on a compound annualized basis.  Investors create this gap by entering and exiting the market at the wrong time and switching out of previously underperforming funds into outperforming funds only for the relative outcomes to subsequently reverse.  Over a long time, this gap can lead to a significant performance disadvantage, one that is entirely avoidable by merely remaining invested and avoiding excessive trading.

You have likely seen us reference this Morningstar study in the past.  The study bears repeating now because investing mistakes can cluster in certain extreme market environments.  For instance, in a runaway bull market fueled by speculative excess and in a down market when it seems that there is no place to hide.  2021 is an example of the former, and last year is an example of the latter.

I remember an article that caught my attention in late 2021.  The headline from the Wall Street Journal was “Morgan Stanley Gives Rich Customers What They Want: Hot Startups”.  The market for initial public offerings (IPOs) was booming, and the bank was building a program to provide access to private companies before they listed on a public stock exchange.  This program was reserved for those clients with more than $20 million to invest.

The largest U.S. initial public offerings in 2021 included cryptocurrency investment platform Coinbase, the video game company Roblox, electric vehicle manufacturers Rivian and Lucid, as well as designer prescription glasses company Warby Parker.  On average, the ten largest U.S. IPOs of 2021 lost approximately -60 percent of their market values in the year that followed the publication of the WSJ article.  

The mistake made by IPO investors in 2021 was extrapolating into the future the recent stellar performance of technology companies and newly public companies.  With the benefit of hindsight, those investors needed to exercise more caution.  

The opposite investment mistake is possible today.  2022 was a historically bad year for financial markets.  U.S. stocks declined -18 percent, the seventh-worst calendar year since 1926.  U.S. bonds had their worst year ever.  It would be a mistake to conclude that the outlook won’t eventually improve.  In general, a key to avoiding costly investment mistakes is to lean away from the prevailing market sentiment and adopt a “this too shall pass” mindset.

A fallacy in investing is that consistently following a diversified strategy is a ticket to average results.  On the contrary, avoiding making mistakes like the ones discussed in this letter is a path to above-average results.  Recognizing that markets are unpredictable and avoiding strategy changes at market extremes are the “simple but not easy” ways to meet your investment objectives.

As always, we look forward to our next conversation.

1.  Credit to my colleague, Eric DeMico, for the inspiration for this comparison.  Data from Koyfin.com from 2/28/20 through 12/31/22.
2.  From initial public offering in late 2020.
3.  If you are wondering if professional money managers were able to profitably trade in and out of the “stay at home” stocks before they declined in value, consider that about 85 percent of large company US stock funds underperformed the S&P 500 in the three years ending June 30, 2022.  Data from S&P Dow Jones Indices SPIVA®.
4.  For the most recent 10-year period, see https://www.morningstar.com/articles/1101942/are-you-leaving-money-on-the-table-from-your-funds-returns.  
5.  Hoffman, Liz. (2021, November 9). https://www.wsj.com/articles/morgan-stanley-gives-rich-customers-what-they-want-hot-startups-11636453801
6.  11/10/21 through 11/9/22.  Data from Koyfin.com.