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The Big Mistake Investors Still Make

April 7, 2016

 

Investors still buy funds and sell at the wrong times, especially in volatile markets

 

Volatility has taken hold of the financial markets, and it’s likely to bring out the worst in investors.

This year, the S&P 500 index swooned nearly 5% in January, remained flat in February, and surged more than 6.5% for the month of March. That’s after erasing last year’s August-September 8% drop with an 8.4% October gain.

 

Moreover, smaller-company stocks, represented by the Russell 2000 index, were down more than 20% from their late-summer peaks in February, before storming back more than 10% since then.

 

Moves like this drive investors crazy, often causing them to trade their holdings in damaging ways.

 

Here’s how investors hurt themselves, and what they can do to stop it.

 

Missing Out

 

Fund-research firm Morningstar Inc. has the data to prove investors’ self-defeating behavior, in the form of a metric called “investor returns.”

 

An investor return differs from a fund’s total return in that the total return assumes a buy-and-hold approach. The total return doesn’t reflect money moving into and out of the fund, and, therefore, judges the manager’s performance accurately.

 

But an investor return, sometimes called a dollar-weighted return, accounts for cash flows into and out of a fund, and evaluates how much of the fund’s return the average dollar invested in the fund has extracted. In other words, it shows how well or poorly investors trade their funds.

For example, if a fund’s investor return is less than the total return, fewer dollars participated in the fund’s upswing and more participated in the downswing.

 

For example, if a fund’s investor return is less than the total return, fewer dollars participated in the fund’s upswing and more participated in the downswing.

 

 

This can happen because investors have sold a fund near its lows, leaving fewer dollars in the fund to take advantage of the upside, and bought it near its highs, pushing more dollars into the fund to inadvertently capture its downside.

 

Sadly, this kind of negative “return gap”—lower investor return than total return—is the norm. Morningstar’s data shows investors in diversified U.S.-stock funds (those not limited to a particular sector of the market) have missed nearly 1.8 percentage points of the funds’ annualized total returns over the past decade because of bad trading. The gap over the past 15 years is negative 1.6 percentage points, implying investors are getting worse at timing their trades.

 

If 1.8 or 1.6 percentage points doesn’t sound like a lot to give up, consider how much just 1 percentage point a year can cost you over a lifetime of saving. Investing $5,000 a year for 40 years and earning a 6.5% annualized return results in nearly $880,000. Investing the same amount over the same period but earning a 5.5% annualized return results in about $680,000. So in this case, losing 1 percentage point of annualized return due to bad trading would cost you 23% of your potential final sum.

 

Check yourself

One way to prevent yourself from buying high and selling low is to set up allocations that don’t scare you when the market drops.

 

When the market is going up, people tend to feel confident and fool themselves into thinking they can handle any risk. Then, when the downturn arrives, they find they didn’t plan well enough for how they would feel with losses mounting in their portfolios.

 

Try to anticipate how a large stock-market decline will feel before it’s upon you. Behavioral-finance experts call this approach minding the “empathy gap.”

 

A good way to mind the gap is to think about how you felt during the last big decline, in 2008-09. If you sold stocks into the downturn, you didn’t have a good equity allocation. If you have the same allocation now, you need to change it.

 

Minding the empathy gap well can help you set up a portfolio that makes you want to buy stocks in a downturn, not sell them. And now is an excellent time to anticipate how a downturn will feel, because, although the market has been choppy lately, we haven’t experienced a serious decline since the last one ended in early 2009.

 

Besides anticipating how a downturn will make you feel, try to remember how social a creature you are. There’s little doubt most of us are wired to be with each other, but this characteristic can hurt us in some ways, including as investors.

 

For example, psychological studies have show