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Still Misbehaving

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Investor behavior is the single biggest obstacle to achieving acceptable longterm returns. Far too many investors are their own worst enemies. They say one thing and do another. For instance, most investors believe that they follow longterm buy and hold policies. Yet, cash flow analysis of mutual funds indicates that investors ruthlessly churn their own portfolios, in the process routinely under-perform the funds that they invest in by wide margins.

At first blush, even clueless investors should be protected from such underperformance by efficient markets. After all, it shouldn’t be possible to either under or over perform markets in the long term on a reliable basis. However, investors routinely achieve sub standard performance. The paradox is troubling.

A new paper in the November 2001 Journal of Financial Planning, “Investors Behaving Badly: An Analysis of Investor Trading Patterns in Mutual Funds”, by Gavin Quill resolves the conflict by comparing the timing of mutual fund cash flows to market prices. It’s no secret that cash flows follow market performance. When markets rise, investors pour in. When markets fall, many head for the doors. Of course, this is the classic self-defeating, buy high, sell low, market timing route to investment failure. The paper’s author presents “an elaborate flow-weighted returns analysis, which compares the returns investors actually experienced with what they might have achieved if they had behaved more “rationally.”

In real life, the loss of returns is not trivial. Investors fall short of achieving even reasonably attainable financial goals due to behavior that appears hard-wired for failure. Worse yet, they don’t “own” the problem. They attribute short-term market timing to their neighbors while absolving themselves.

Unfortunately, the paper finds that investor behavior as related to turnover and redemption rates is getting worse. The avalanche of data and the convenience of trading in the information age “empowers” investors to behave irrationally and against their own best interest.

Investor, heal thyself! The key to better performance is to understand how inappropriate and irrational our behavior can be when making financial decisions under stress, and then to avoid repeating past mistakes. This paper should be required reading for all investors. Might I suggest that it would be a good way to start your new year?