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.
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Boston-based Dalbar recently released its 20th “Quantitative Analysis of Investor Behavior,” a landmark study that 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 then repeat the process.
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 500 index returned 9.22 percent over the 20-years ending in 2013, but the average equity fund investor only earned 5.02 percent.
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 the “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 percent 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.
Barring that, however, the way to combat human nature is to only succumb to it when you first buy a fund, and to fight it thereafter through buy-and-hold or systematic investing where buy-sell decisions are based on individual needs and not on recent results and current conditions.
Make no mistake, however, that virtually everyone does fall prey to a classic investment mistake right from the moment they make a purchase decision.
Investors just don’t buy funds that haven’t shown an ability to deliver.
If performance is not unique enough to warrant an investor taking a chance, they won’t roll the dice on the fund.
It’s why more than 90 percent of all money going into funds winds up in issues carrying four- or five-star ratings from Morningstar.
That’s not to say that investors should look for funds with lousy track records and assume they will get a turnaround, because ugly ducklings seldom become swans outside of fairy tales.
It’s more than investors should assume that whenever they decide to buy a fund, they will have lousy timing on it, at least for the short term, and they should be prepared to live with that.
“No matter how much people have been educated that past performance is no guarantee of future results, they want to buy what’s been hot and they expect it to stay that way,” said Lou Harvey, Dalbar’s president.
“But even if you say it’s human nature to buy funds at the wrong time, you can still go off and buy good funds — ones where there is a higher probability of the future delivering good results like the past — and then getting the performance of those funds from the moment you buy them forward,” Harvey said.
Getting performance that is as close to the fund’s returns as possible means holding the fund, and making either no additional purchases or deposits at regular intervals, where time — and not recent results — decides when the money is in.
Likewise, withdrawals should be based on needs, rather than market calls, he said.
In the end, buy decisions aren’t bad so much as “suboptimal;” the key to success therefore, comes in remembering that what matters most isn’t how you start, but how you finish.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at email@example.com or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright 2014, MarketWatch