Continued Bad Behavior

Morningstar has new data out from their Investor Returns research.  In these studies, Morningstar uses the cash flow data on when investors buy and sell mutual funds to determine how well (or poorly) investors time these transactions.  This shows us if investors successfully buy high and sell low and if they successfully participate in the out-performance of an active manager. The results?

Morningstar 2014 Behavior

Dismal. Just awful, really.  Astonishingly, US stock funds had the smallest underperformance over the last decade.  No asset classes were spared.  Taxable bond investors underperformed their funds by -2.24%, surrendering 40% of their gross returns to bad behavior. For a $50,000 position, this is the difference between ending with $84,520 or ending with $68,180. Sector funds, where people are likely trying to time the market, had the biggest gap with annual underperformance of -3.14%, a third of the total return available in the funds.

My favorite example is the alternative investment category, where funds barely edged out a positive return over the last ten years, but their investors suffered an annualized loss of over 1%.

What’s most amazing about this data is that it isn’t news.  These numbers almost never change.  DALBAR has been doing their version of this study (called the Quantitative Analysis of Investor Behavior) since 1994 and shows nearly the same results every year. Maybe human nature will never change. We chase performance, always trying to get in on what “is performing best” and end up buying only what recently performed best.

Investors can take two steps to avoid the pitfalls of bad behavior.

First, we should all stop chasing “hot” fund managers.  There is plenty of research that demonstrates that even institutional investment consultants hire fund managers after a hot streak, only to suffer through underperformance and fire the managers at the bottom. Using a broad-based index fund strategy will alleviate the need to constantly question whether or not they have the right manager in place.  There is some good evidence that this is effective.  Investors in the Vanguard Total Stock Market Index Fund have actually had a positive behavior gap – that is that the investors in the fund have outperformed the fund itself. You can see below thank thanks to good behavior and rebalancing, the fund’s investors did very well (data from Morningstar).

VTSMX Investor

Second, and just as important, investors need to have an investment policy statement in place.  This document will outline, among other things, a target long-term asset allocation and a rebalancing policy.  Investment policy enables investors to avoid the siren song of emotional investing.  It forces individual investors and professionals alike to do the opposite of what our prehistoric brains want us to do.  It tells us to sell high and buy low and not chase recent performance trends. A written investment policy helps us manage our behavior and restrain our worst impulses.

Taken together, these two steps will go a long way for investors to reduce the performance gap created by bad behavior.  Maybe we will eventually learn and the next ten years will look better for investor returns.  Maybe.

(Any information presented above is for informational and educational purposes only and should not be considered investment advice.  No recommendation is given to buy or sell any particular security.)

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