Are You "Dumb Money"?

Last Updated May 28, 2010 2:38 PM EDT

It seems to be a common human failing to fall prey to "recency" -- the tendency to give excessive weight to recent experience, while ignoring the lessons of long-term historical evidence. Unfortunately, this trait leads to expensive mistakes. By examining the evidence from the study, "Dumb Money: Mutual Fund Flows and the Cross-section of Stock Returns," you'll learn why individual investors are referred to as "dumb money."

The study measured investor sentiment by examining the cash flows of individual retail investors into and out of stocks and mutual funds. The following summarizes the authors' conclusions:

  • In the very short term (three months), individuals represent "smart money." The performance of funds that experience inflows is significantly better than the performance of those that experience outflows. The outperformance is likely explained by the "momentum effect" -- the short-run tendency of stocks/asset classes to continue moving in the same direction.
  • However, individual investors represent "dumb money" over the long term. Stocks and mutual funds that exhibit high sentiment underperform those that exhibit low sentiment. And the effect is sizable. Over horizons between six months and five years, high-flow stocks underperform low-flow stocks by between 4.3 and 10 percent per year. Thus, on average, individual investors lose money on their mutual fund reallocations and stock trades.
  • On the other hand, the authors found that firms were "smart money," systemically exploiting individuals. For example, when investor sentiment is high, firms issue more shares via seasoned equity offerings and stock-financed mergers. When sentiment is low, firms tend to repurchase shares.
  • The sentiment effect is so strong that high sentiment growth stocks actually underperform Treasury bills and low sentiment growth stocks have high returns.
The authors concluded that individual investors demonstrate a striking ability to do the wrong thing -- they're "unambiguously dumb" -- causing significant wealth destruction. The cost of the sentiment effect is estimated at almost 1 percent a year. Thus, individual investor behavior costs almost as much as the entire mutual fund industry!

Legendary investor Benjamin Graham stated: "The investor's chief problem -- and even his worst enemy -- is likely to be himself." The evidence supports Graham's belief. You can avoid this destructive behavior by recognizing that investors subject to recency are like generals always fighting the last war. To avoid becoming subject to recency, you must learn to ignore the media, the financial press and "expert" advice from Wall Street that urges you to act on the mistaken assumption that this time it's somehow different.

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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.