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Congrats, Investors! You’re Behaving Less Badly than Usual

A fair argument can be made that investor behavior is among be the most important factors in the success of an investment strategy. Please enjoy the following article written by wsj.com

Congrats, Investors! You’re Behaving Less Badly than Usual

Investors tend to buy high and sell low. But new evidence suggests that may be changing… for now

By Jason Zweig

On the eternal treadmill of the financial markets, investors can’t even keep up with their own investments.

In what’s often called the behavior gap, investors underperform the investments they own, partly because they tend to buy high and sell low instead of vice versa.

New evidence suggests investors may be behaving better — but they aren’t turning into financial angels.

A study published this month by Morningstar, the investment-research firm, finds that the average mutual fund gained 5.79% annually over the 10 years ending March 31; the average investor, 5.53%. That gap of 0.26 percentage points is much narrower than in the past; over the 10 years through the end of 2013, investors lagged their investments by a horrific 2.5 percentage points annually.

What’s behind this puzzle?

Let’s imagine a fund that starts with $100 million in assets and earns a 100% return from Jan. 1 through Dec. 31. Assuming that no one added or subtracted any money along the way, $100 million at the start of the year turns into $200 million at the end.

Attracted by that spectacular 100% return, investors pour $1 billion into the fund overnight. It thus begins the New Year with $1.2 billion. This year, however, its investments fall in market value by 50%.

After gaining 100% in year one and losing 50% in year two, an investor who had bought at the beginning and held until the end without any purchases or sales would have exactly broken even. (Losing half your money after doubling it puts you back where you started.)

Such rigid buy-and-hold behavior doesn’t describe what the fund’s investors did, however. Only a fraction of them were present at the beginning to double their money, while all were around in year two to lose half their money. As a group, they gained $100 million in year one — but lost $600 million in year two.

Adjusted for the timing and amount of inflows, the typical investor lost an average of about 43% annually — in a fund that officially reported a 0% return over the same period. The investment broke even; its investors took a beating because of their own behavior.

In real life, the gap between investors and their investments is rarely that extreme. On average, trying to do better makes you do worse: It feels great to buy more when an investment has been going up, and it hurts to buy more when an asset has gone down. So you tend to raise your exposure to assets that have gotten more expensive (with lower future potential returns) and to cut it — or at least not to buy more — when they are cheaper (with higher future returns).

When you chase outperformance, you catch underperformance.

Why, then, does the new Morningstar report find that investors’ behavior seems to be improving?

The stock market itself, which has risen for most of the past decade with remarkable smoothness, deserves much of the credit.

“Extreme volatility triggers emotional responses that lead you to screw up,” says Russel Kinnel, author of the Morningstar report. With so few stabs of panic in recent years, staying invested has felt unusually easy.

Fran Kinniry, an investment strategist at Vanguard Group, says investors have increasingly favored index funds, which hold big baskets of stocks or bonds, as well as so-called target-date funds that bundle several types of assets into one portfolio. Both approaches blunt the jagged fluctuations investors would suffer in less-diversified funds that focus on narrower market segments.

More financial advisers are seeking to keep their clients’ portfolios aligned with target allocations to stocks, bonds and other assets, says Mr. Kinniry. That means they automatically sell some of whatever has recently risen in price, using the proceeds to buy some of whatever has dropped. That’s a mechanical counterweight to the natural human tendency to buy high and sell low.

When Mr. Kinnel is asked whether these changes mean that investors and their advisers won’t bail out at the bottom during the next crash, he sighs.

“No,” he says after a long pause. “Advisers and individual investors still have an inclination to chase performance, to fight the last war, to panic a bit. People are still people. They’re still going to be inclined to make the same mistakes.”

And so they are. Spooked by recent poor performance, investors are pulling out of international and emerging-market stock funds, even though those markets are significantly cheaper than the U.S. Through June 26, investors have yanked $12.4 billion out of global equity funds, according to Trim Tabs Investment Research, putting June on track for the biggest monthly outflow since October 2008.

The more investors change, the more they stay the same.

Write to Jason Zweig at intelligentinvestor@wsj.com, and follow him on Twitter at @jasonzweigwsj.

This article was prepared by a third party for information purposes only. It is not intended to provide specific advice or recommendations for any individual. It contains references to individuals or entitles that are not affiliated with Cornerstone Wealth Management, Inc. or LPL Financial.

Investing in stock includes numerous specific risks including: the fluctuation of dividend, loss of principal and potential illiquidity of the investment in a falling market.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Investing in mutual funds involves risk, including possible loss of principal.

Asset allocation and diversification do not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.

An investment in a target date fund is not guaranteed at any time, including on or after the target date, the approximate date when an investor in the fund would retire and leave the workforce. Target date funds gradually shift their emphasis from more aggressive investments to more conservative one based on the target date.

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.