How Not to Invest in Mutual Funds, Part Two

In my post last week, which examined the performance of mutual fund investors, a reader posted an excellent question. Might the unfortunately timed swings in asset allocation -- and the performance lag that resulted -- be attributable to investors not rebalancing their accounts, as opposed to true performance chasing?

It's a great question because the reader's line of thinking is correct. Many mutual fund investors -- and specifically, many 401(k) investors -- take a "set it and forget it" approach to investing. After establishing their initial asset allocation, these folks make no changes going forward. They don't rebalance as market returns throw their allocation out of whack, pour out of stocks during bear markets, or pour into them during bull markets.

Last fall the Wall Street Journal's Jason Zweig called this group "sitting bulls," and reported that only 16 percent Vanguard's 401(k) investors had made any trades during 2008.

So is it possible, then, that the gap between the performance of mutual funds and mutual fund investors is simply the result of the investors' failure to rebalance their accounts, thus letting their allocations stray from their original (presumably appropriate) setting?

Unfortunately the answer is no. For however unresponsive a segment of investors may be with their existing balances, there is still a great deal of performance chasing going on.

At the risk of inducing chart overload, there is simply no better way of illustrating this phenomenon than examining mutual fund flows against the performance of the equity markets.

Below are four charts, each showing the annual net cash flow into a segment of mutual funds from 1990 to 2009 plotted against a market index. Total equity fund flows are plotted against the annual close of the S&P 500. Flows into international equity funds are plotted against the MSCI EAFE index; emerging market flows against the MSCI Emerging Market index; and technology fund flows against the NASDAQ.

Looking at each chart, the pattern is as simple to see as it is staggering in scale. In each case, we see low levels of mutual fund cash flow prior to impressive stock market gains, with cash flow ramping up as the market does, peaking just as the market reaches its highest point. And once market performance falters, cash flow dries up (or even turns negative), as chastened investors seek out better alternatives for their new money.

Clearly these patterns go a long way toward explaining how the typical fund investor has earned returns far below both the overall market and the funds they invest in. How do we reconcile this behavior with the fact that, once invested, many investors just let their money sit?

We turn, once again, to Jason Zweig, who has spent a great deal of time studying the field of neuroeconomics -- which examines the neurological explanations for the decisions investors make. It turns out that most investors are hesitant to sell their losers. After being burned, we hang in there, hoping that the markets will eventually get around to proving that the decision we made wasn't such a dumb one after all. Meanwhile, as the cash flow data show, we resume the hunt in other sectors of the market with the new cash we put to work.

And now, one final chart, which depicts the flow into gold funds against the price of gold. I'll leave the debate about the long-term outlook for gold to wiser heads. But considering the pattern depicted below and its similarity to that shown in the previous four charts, I would think long and hard about my motivations if I held, or was considering establishing, a large allocation of gold in my portfolio at this moment.