Consistency + Discipline = Success
There will always be get-rich-quick schemes in the financial markets. The latest trend happens to be in extremely short dated options contracts, often those expiring within a day or less. Options give the holder the right to buy or sell shares of a stock or other financial security at a given price. If you are the owner of a call option and the price of the stock tied to the option rises above the price at which you have the right to buy, the value of that option can rise significantly. The value of an option is dependent on the time until the option expires (time value), the price of the underlying stock or security relative to the price at which the option allows you to transact, and the volatility of the price of the underlying stock or security (i.e. how much the price moves around). With options that are very close to expiration, the time value is minimal so the option value is much more dependent on the second two factors. This can lead to large swings in value and potentially huge payoffs. The prospect of these outsized returns has driven individuals to such short-dated options. Over the last few years, the trading volume of options expiring within 5 days has risen to almost 50% of total option volume, much of it fueled by individual retail investors (WSJ).
While exhilarating, trading these options tends to be a losing proposition. As referenced in a previous post, Stock Returns Over Different Time Horizons, the percentage of days in which the S&P 500 has had positive returns has been slightly better than a coin flip at 53%. Letting those slightly greater than 50% odds accumulate over time can lead to big winnings in the stock market, but betting on any one of those flips is typically a loser’s game. There are so many factors that can affect the market on a day-to-day basis that predicting the moves of any one day is virtually impossible. Often, it looks completely unpredictable even in retrospect.
Strategies or trades that offer the prospect of quickly achieving high returns attract so much attention because patience and discipline in the markets is so hard. The average investor in mutual funds and ETFs has historically underperformed the actual returns of their funds by a significant margin. Morningstar's "Mind the Gap" report finds that investors earned a 6% annual return on the average dollar invested in mutual funds and ETFs over the 10 year period ended 12/31/22, while the funds themselves earned a 7.7% annual return over that period. It is no surprise that the worst gap between investor returns and fund returns was present in those funds that track specific sectors. Rotating out of your current portfolio holdings to invest in the latest high-flying strategy or sector exemplifies the return chasing that is so common amongst investors. The subtle truth in the markets is that doing nothing and sticking with a portfolio that is designed to fit your plans and needs is really all you need to do.
Legendary investor Howard Marks recounts in a recent memo (Fewer Losers, or More Winners?) two contrasting approaches to achieving above average investment performance over time. One investment manager, after a very bad year of performance, states that “if you want to be in the top 5% of money managers, you have to be willing to be in the bottom 5%”. On the other hand, Marks summarizes a dinner he had with the head of a pension fund who achieved investment results over a 14-year period that were better than 94% of his peers. The underlying annual results of this manager over the period were never better than 27th percentile (better than 73% of peers) but never worse than 47th percentile. Without having any single year of incredible returns, this manager was able to drastically outperform his peers by being consistently modestly above average and by never having a year in which the pension fund was at the bottom of its peer group. Rather than swinging for the fences, this manager racked up singles and doubles and achieved a stellar long-term track record.
While pension fund management and institutional asset management can be quite different from managing your own investments, there are important lessons that translate to personal finance. At its essence, above average investment performance can be achieved by avoiding costly mistakes, staying consistent with an approach that is aligned with your goals, avoiding chasing the hot investment trend, and letting your returns compound over time. As an individual, you can outperform a lot of your peers by being disciplined and avoiding costly behavioral errors. Fear of missing out, overconfidence, loss aversion, herd mentality, regret aversion, and a host of other behavioral biases are all an investor’s enemy. If you can limit these forces, you will do better than many of your peers.
The stories of people hitting it big off of a single stock, options trading, or leveraged investing are wrought with survivorship bias. For every one of these success stories, the landscape is littered with costly losses and failures. The path to strong long-term returns is most likely achieved through putting on your blinders, ignoring the noise, avoiding the latest fad, and letting your portfolio compound uninterrupted.
(for a refresher on the magic of compounding, see below table of annual returns/time periods/ending balances and also read here)