Reacting to Returns and Volatility Can Hurt Your Portfolio

(MoneyWatch)  When tough market times hit, it's natural to want to flee toward safety. However, letting your emotions get the best of you can be detrimental to your investments.

In 2006, the S&P 500 Index rose 15.8 percent, and purchases of shares in U.S. registered stock mutual funds exceeded redemptions by $159.4 billion. By the last half of 2008, the bear market led to a reversal of flows with redemptions exceeding purchases by $214.6 billion. This is typical -- aggregate stock fund flows are positively correlated with stock market returns, as shown by the study "Evidence on Investor Behavior From Aggregate Stock Mutual Fund Flows."

The authors found that returns only impact inflows -- when returns increase, aggregate inflows rise, but outflows don't slow. Thus, the relationship between returns and flows is entirely related to the effect on inflows. They also found that when volatility (as measured by the VIX) increases, equity fund inflows actually increase, though not as much as outflows. Thus, the net flow relationship caused by volatility is entirely due to the effect of volatility on outflows.

The authors concluded that mutual fund investor purchase decisions are primarily driven by returns, while redemption decisions are primarily driven by risk perceptions. The question we need to answer is: Is the observed behavior productive?

The data demonstrates that, in aggregate, mutual fund investors increase inflows after observing periods of strong performance. They buy at high prices, when future expected returns are lower. The problem doesn't end there.

Volatility is a measure of risk. When volatility increases, investors demand a larger equity risk premium as compensation for the increased risk. This results in investors attempting to move from equities to riskless assets, causing a drop in equity prices and an increase in expected returns. Thus, investors tend to sell just when expected returns have increased.

Warren Buffett recommends: "If they [investors] insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful."

The winner's game is to rebalance your portfolio whenever your allocations drift too far. Rebalancing requires you to fight the tendency to buy high and sell low. By purchasing the assets that have recently underperformed, you're instead buying low, when future expected returns are higher. And by selling the assets that have recently outperformed, you're selling when future expected returns lower.

Seems obvious, doesn't it? Unfortunately, rebalancing for investors is like following a healthy diet and exercise to lose weight -- a concept both easy to understand and hard to practice.