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Investors Get It Wrong -- Again

Many investors sell when they should be buying, and vice versa.According to Morningstar, investor behavior has, yet again, led to investors underperforming the very funds in which they invest.

Being subject to recency (which involves looking at yesterday's returns and projecting them forward) causes investors to buy (high) after periods of strong performance (when expected returns are now lower) and to sell (low) after periods of poor performance (when expected returns are now higher). The result is that the dollar-weighted returns earned by investors (investor returns) are actually lower than the time-weighted returns earned by the very mutual funds in which they invest (investment returns). The difference between investor returns and investment returns is a behavioral gap.

The latest example of investors behaving badly comes from Morningstar. Once again, the past few years saw investors going the wrong way, moving assets from equity funds into bond funds, causing them to miss out on one of the greatest bull markets ever. The following data presents the behavioral gap for the one- and three-year periods ending December 2010:

  • Domestic equity funds -- 2.0 percent and 1.3 percent per year, respectively
  • International equity funds -- 0.6 percent and 0.8 percent per year, respectively
  • Taxable bond funds -- 1.4 percent and 0.5 percent per year, respectively
  • Municipal bond funds -- 1.1 percent and 1.5 percent per year, respectively
Investor activity cost tens of billions a year. The only category where the gap was relatively minor was for balanced funds. For both one-year and three-year periods, the gaps were 0.1 percent per year. Perhaps this is an advantage of balanced funds -- investors in these funds tend to pay less attention, which the evidence demonstrates is a good thing.

The evidence demonstrates very clearly that investors would benefit greatly from learning from Warren Buffett, who stated in Berkshire Hathaway's 1991 annual report: "We continue to make more money when snoring than when active." In other words, at least when it comes to investing, inactivity is usually the better strategy. Remember this the next time you're tempted to alter your asset allocation in reaction to the market's latest move.

While the evidence shows that for most investors doing nothing is a far better strategy than activity, you can do improve on the do-nothing strategy. By regularly rebalancing your portfolio to the asset allocation you have written in your investment policy, you'll be doing the opposite of what the typical investor does -- you'll be buying what has done relatively poorly (low) and selling what has done relatively well (high). Buying low and selling high is a much better strategy than buying high and selling low. And that's what rebalancing accomplishes. There's no need to either make market forecasts or to pay attention to guru forecasts.

Photo courtesy of KungPaoCajun on Flickr.
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