Most investors make a bad decision the minute they pick a mutual fund. The key to successful fund investing, therefore, becomes not turning that one bad decision into a multitude of mistakes. The problem here isn’t funds, however, so much as human nature, but since a prominent study shows that basic investor behaviors aren’t changing, it’s time that fund investors figured out how to make the best of their bad thoughts.
Boston-based DALBAR Inc. just released its 20th “Quantitative Analysis of Investor Behavior,” a landmark study which has shown since it was first done in 1984 that investors lag the mutual funds they buy, with seemingly every move working against them.
The tale is hardly new. Investors buy a fund after a period of good performance, waiting for the fund to prove something before adding it to their portfolio. But when the market turns and the fund’s asset category cools — or when today’s hot manager regresses toward the average after a period of oversized results — investors bail out, and look for another fund to buy, typically choosing again something that’s been hot lately. In short, they buy high and sell low, and repeat the process multiple times.
In general, fund investors sacrifice the good — decent funds with reasonable returns — to pursue the great, and wind up with neither. DALBAR’s study quantifies the phenomenon. The Standard & Poor’s returned 9.22% over the 20 years ending in 2013, but the average equity fund investor only earned 5.02%. Why?
Well, DALBAR noted that investors truly are at their worst when the market does poorly, selling once they have a big paper loss and sitting on the sidelines until the markets have recovered their value, thus participating in the market mostly when it is in retreat and sitting out the times when securities are on the rise.
One key part of the DALBAR analysis is its “Guess Right Ratio,” which looks at fund inflows and outflows to see how often investors correctly anticipate the direction of the market. If net inflows are followed by market gains (meaning investors were rewarded for throwing more money into their funds) or net outflows are a precursor to a decline (meaning investors sought shelter just in time), then investors guessed right.
Guess right more than half the time and you’d expect to be making decent money; in fact that DALBAR study shows that, historically, that’s how it works.But then you get a year like 2013, which only had two down months. Investors “guessed right” 75% of the time, but they were still lousy market timers. None of the S&P 500’s best six months during the year followed a month in which fund inflows were significantly above average.
The easy fix to the problem is simple, but nearly impossible: be better at guessing the market’s direction.