Don't Underperform Your Own Funds

Last Updated Feb 3, 2011 3:11 PM EST

One of the biggest mistakes investors make is to underperform their very own funds. Let's see how this happens and how you can avoid it.

This shocking result is caused by investing as if driving forward while looking through the rear view mirror. Investors plow into asset classes after periods of strong performance and sell them after periods of poor performance. Two great recent examples:
  • After the bear market of 2008, investors moved hundreds of billions from equity mutual funds to bond funds.
  • After the bull markets of the 1980s and 90s, pension plans dramatically raised their equity allocations. After the bear market of 2008 they lowered them.
As we have discussed many times here, the evidence on market timing is dismal, yet investors persist.

A related tragedy is that investors persistently underperform risk-adjusted benchmarks. Once again, it's because of their tendency to buy past winners. The evidence from studies on individual investors, mutual funds, pension plans and hedge funds is that the SEC is wrong in its disclaimer that past performance is not a guarantee of future performance. The statement should be much stronger, saying past performance has virtually no value as a predictor of future performance. (Past losers with high expense ratios do tend to persist in their underperformance.) The evidence from many studies shows that both individuals and institutional investors invest with funds that have delivered alpha. However, after the investment is made the alphas turn negative. That leads to changing managers, and the pattern repeats itself.

I have asked hundreds of investors why they keep doing what Albert Einstein said was the definition of insanity: repeating the same behavior and expecting different results. I ask them why if they hired a great manager only to find that the results were poor after hiring, what they're doing differently in their due diligence to prevent that mistake from reoccurring. I have never gotten an answer to that question, just blank expressions. The reason is that they're not doing anything different and it never occurred to them to think what would happen if they didn't change something.

Follow the series:
How to Avoid Financial Errors Don't Underperform Your Own Funds Don't Listen to Economic Forecasters Don't Lose Sight of What's Really Important The Greatest Beneficiary of a Passive Investment Strategy? Your Family
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Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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