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Whether it's crypto last quarter or the Mag Seven-led S&P of the past two years, FOMO is natural when we see big gains. Hey, we’re all human. As a tribal species, much of our happiness is centered not on absolute success, but on our neighbor’s success.
And that innate relativism means we’re hard wired for seeking “more.” Now, more is generally good in evolution and economics. More helps weed out the weaker species and the inefficient businesses. But, when your investment objectives become “more”, you’re likely to be on the path to disappointment and, counterintuitively, worse long-term returns. How is that? More tilts you towards return chasing and concentration, both of which erode long-horizon investment success. Let’s examine each.
Cathie Wood’s ARK Innovation ETF (ARKK) serves as a cautionary tale for return chasers everywhere. Once a darling of innovation-focused investors, ARKK was later dubbed the “largest wealth-destroying fund of the past decade” by Morningstar – not because of the strategy itself, but because of investors’ disastrous timing.1 Chasing its meteoric rise, they piled in after strong performance, only to bail during the subsequent downturns. The result? Returns for the average ARKK investor significantly trailed the fund itself. How much? Morningstar estimated that the fund lost over $7 billion of shareholder value, a horrific amount for a fund that ended 2023 with $9 billion in assets.
This isn’t an isolated case. Research by Hsu, Whitby, and Myers (2016) studied equity mutual funds over a 24-year period, and found all categories suffered a behavior gap between investors’ returns and those of the funds they own. For growth funds, the average investor lagged behind fund performance by 3.2% annually. Sector funds were even worse. Similar results have been confirmed in other peer reviewed articles from academia. Investors who chase returns get less, not more.
Now, let’s talk concentration. Big scores, especially the ones that create the most FOMO, almost always come from concentration. Concentrated investments may seem bold, but a recent paper by Nathan Sosner (2022) makes clear, boldness and long-term wealth preservation rarely mix.2 His analysis shows that while a single stock might boast an enticing average return, the median and mode – the more likely outcomes – are far less rosy. How come? Over time, volatility in a concentrated position relentlessly drags the majority of outcomes toward zero. The math is brutal: compounding can't undo large drawdowns, and the probability of catastrophic loss grows with both time and volatility. If you think you're holding the next Google or Amazon, remember that for every unicorn, thousands of single stocks deliver a one-decade return of – brace yourself – negative 100%.
The two perils of “more”
These thoughts echo the most succinct and influential treatise on investing I’ve come across in the past 30 years: Charles Ellis’ Investment Success in Two Easy Lessons. (2016).3 Charles is the legendary financial writer, former Investment Committee chair at Yale, and long-time trustee at Vanguard. His advice to "run your own race" and "don’t lose" highlights the importance of setting realistic, personal objectives and avoiding the temptation to outperform others – a mindset that often leads to poor timing and reckless decisions. Concentration, in particular, mirrors the risks of teenage driving: Just as young drivers often overestimate their abilities, leading to catastrophic accidents, concentrated investments expose portfolios to volatility and the irreversible damage of large drawdowns.
What does all of this mean for the financial advisor? A household’s essential and important financial priorities generally shouldn’t be tied to risky, “more” oriented investments. That’s why Flatrock Wealth Partners designed our Protective Reserve and All Seasons Growth exposures to meet financial priorities over long time horizons, by both diversifying and refraining from chasing returns. Only if a household has excess, liquid resources beyond all priorities, can the trade-off to a “more” investment make sense.4 In other words, consider pursuing high-risk strategies only when you can afford to lose.
John West co-founded Flatrock Wealth Partners in 2022. He brings over twenty-five years of investment and management experience to the firm. John is a member of the Flatrock Management and Investment Committees and is involved in all aspects of the firm’s operations, investment management functions and client experience. Previously, John spent fifteen years at Research Affiliates, a global asset manager known for its work in asset allocation and equity indexing.
A recognized thought leader, John’s original research and publications have been cited in Barron’s, Financial Times, Wall Street Journal, The Economist, Institutional Investor, InvestmentNews and Advisor Perspectives. He also co-authored Fundamental Index: A Better Way to Invest (Wiley 2008) an honorable mention award winner at the American Publishers Awards for Professional and Scholarly Excellence (The PROSE Awards).
ENDNOTES
1 https://www.morningstar.com/funds/15-funds-that-have-destroyed-most-wealth-over-past-decade The author, Amy Arnott, confirmed my observation, “The worst results in terms of wealth destruction tend to come from more specialized or volatile categories of funds.”
2 Sosner, N., “When Fortune Doesn’t Favor the Bold: Perils of Volatility for Wealth Growth and Preservation.” The Journal of Wealth Management, Winter 2022, 25 (3) 10-36.
3 Ellis, C. D. (2005). Investing Success in Two Easy Lessons. Financial Analysts Journal, 61(1), 27–28.
4 The other exception would be human capital. Most of our clients are *very* concentrated in their own human capital and owning a portion of their own enterprise. This tends to be where the aspirational, “next level” wealth is created.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
