More Discipline, Higher Returns
Despite the complexity inherent in much of the finance world, achieving a successful investment experience often boils down to avoiding counterproductive behavior. Among the most damaging of these behaviors are market-timing and performance-chasing. Recent studies detail both the widespread nature of these tendencies and the incredible wealth destruction that can result.
A review of mutual fund flows (i.e., investor purchases and sales) provides an interesting, though unsurprising, perspective on the attitude of individual investors today. Despite seven consecutive months of positive stock market returns, investors continue to demonstrate an extreme prejudice in favor of bonds and against equities. In fact, monthly flows into bond funds have now outpaced those into stock funds for 21 consecutive months!
What this tells us is that rather than rebalancing toward equities through the market downturn, individual investors were steadily moving in the opposite direction. This stands in stark contrast to the positive market environment of 2007, when equity fund flows exceeded those of bond funds. Sadly, this is a reflection of the well-documented propensity among individual investors to buy high and sell low.
A recent academic paper titled “Evidence on Investor Behavior from Aggregate Stock Mutual Fund Flows” explains that mutual fund purchase decisions are primarily driven by returns (i.e., chasing performance), while redemption decisions are largely driven by risk perceptions. Because risk perceptions tend to move opposite of the market – investors perceive tremendous risk at market bottoms but are often exceedingly bullish at market tops – investors are inclined to buy and sell at exactly the wrong times.
The impact of this behavior is underscored by Morningstar data showing that the returns realized by investors often pale in comparison to the total return produced by the mutual funds. To explain, Morningstar reports two types of fund returns:
- Total Return, which represents the performance generated by a fund independent of investor purchases and sales; and
- Investor Return, which incorporates investor cashflows to depict the actual experience of the fund’s investors based on their decisions of when to invest.
For example, assume a fund generated a 20% Total Return in a calendar year, with most of the gain occurring in the year’s first quarter. If investors added substantial sums of money to the fund after its first-quarter surge, the fund’s Investor Return for that year would be meaningfully lower than the fund’s 20% Total Return.
Morningstar has found that volatile funds tend to experience the greatest discrepancies between Total Return and Investor Return – investors are drawn to these funds by dramatic performance upswings (buying high) but ultimately rush to the exits upon inevitable performance declines (selling low). One dramatic example recently highlighted by Morningstar is CGM Focus (CGMFX), a popular large-cap growth fund. Below are the returns of the fund through September 30, 2009:
Investor Return Total Return
1-year -39.32% -35.06%
3-year cumulative -48.80% +3.37%
5-year cumulative -57.70% +45.44%
10-year cumulative -77.71% +498.34%
The trailing 10-year Total Return suggests that a $100,000 investment a decade ago would now be worth $598,341. Stunningly, however, the 10-year Investor Return indicates that the $100,000 dwindled to only $22,285. This startling difference of $576,056 (on just a $100,000 investment) is attributable to consistently mistimed purchases and sales.
Despite their best intentions, the evidence clearly shows that many investors actually destroy portfolio value in their attempt to protect or grow their assets. Conversely, a disciplined portfolio rebalancing strategy can systematically add value over time by capitalizing on volatility across varied investment holdings. Though the long-term effectiveness of this forced buy-low-sell-high approach is glaring, investors often fail to act when it comes time to trim their best performers and add to their worst. A central function of our role as advisors is to serve as a disciplined anchor for our clients, deterring counterproductive action in the face of market highs and lows.