Irrationality leads to poor investment returns

Lynn O'Shaughnessy
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Posted: Dec 19, 2006 12:01 AM
Irrationality leads to poor investment returns

Do you know how well your mutual funds have been doing?

For many of you, this will sound like a question that would stump only a simpleton. Turn on your computer and you can probably find the performance figures for any mutual fund within seconds.

But I'm not talking about those numbers. What I'm curious about is whether you know much about your returns. The reason this is so important is because most of us are experts at sabotaging the returns of our personal clutch of mutual funds.

Our weapons are unchecked fear, greed and a behavior that we should have left behind in middle school: an unbendable desire to do whatever the heck everybody else is doing.

What's become quite indisputable - thanks to an avalanche of academic papers - is that we gut our own returns with our brain waves. Our investment returns, you see, are far more dependent on our behavior, which is often irrational, than on any given fund's performance.

Behavioral finance experts can rattle off what prompts our irrationality. We are pained far more by losses than we are encouraged by gains, so we dump funds when they have lost money. Many of us only feel emboldened to embrace the market again when stocks have nearly reached the pinnacle of Mount Olympus again.

Being addicted by this buy-high, sell-low habit isn't our only transgression. We react to talking heads hyping stocks or mutual funds without giving any thought to whether their advice should be any more credible than the homeless guy holding a poster board at a busy intersection.

We get drawn in by the herd's euphoria. Before dot-com stocks became nearly as worthless as kindling, how many of us started hoarding tech stocks because everybody else seemed to be cruising along a yellow brick road that led to Buffett-sized fortunes?

One of the latest studies that illustrate investors' innate ability to blow it comes from Dalbar Inc., which conducts an annual quantitative analysis of investor behavior. The results share a dreary sameness when it comes to measuring Americans' investment prowess.

In its 2006 exercise, Dalbar examined what kind of returns the typical investor in stock and bond funds would have pocketed from 1986 and 2005 and compared them with two major market benchmarks.

During the past two decades, Dalbar estimates that the average stock fund investor would have generated a yearly return of 3.9 percent. That will probably strike you as underwhelming even before I share what the Standard & Poor's 500 Index generated during that same period: The S&P 500 rose an average of 11.9 percent annually.

Investors' performance stinks because their irrational feelings compel them to regard the market as a high-stakes dodge ball game. They flee when they fear their nest egg is going to get smashed by a well-aimed ball, and they return to the court when they feel emboldened. Investors think they know when to dash in and out of the market, but they don't. Not even the experts know.

The gulf between the market average and investors' typical returns will look even more yawning when you plug in some dollar figures. If the average Joe had invested $10,000, he would have walked away after 20 years with a mere $21,494. In contrast, the S&P 500 would have produced a nest egg of $94,755. That's a difference of $73,261.

Even though bonds aren't as volatile as stocks, Dalbar suggests fixed-income investors are just as skittish. While the long-term government bond index generated a 9.7 percent annual return in the 20-year period, the average bond investor would have eked out a 1.8 percent annual return. Using the same $10,000 initial investment, the fixed-income investor would pocket $14,287 versus $63,699 for the benchmark.

Morningstar, the investment research firm in Chicago, recently studied investor behavior and arrived at the same sort of conclusions. During a 10-year period, researchers found that investor returns lagged behind all the categories of diversified stock funds. Technology mutual funds provided one of the most striking performance disconnects. During the past decade, tech funds posted total annualized returns of 6.4 percent. In contrast, tech investors lost money with an average annual return of negative 4.2 percent.

How can we stop this lunacy? For starters, stop trying to time your investments. If you take all your marbles home and wait on the sidelines until the right moment to get back in the game, you will almost certainly lose. Your best bet is to stay put.

One way to reduce your skittishness is to only invest in the stock market if you have at least a five-year time horizon, and preferably longer. If you aren't going to touch your money for many years, you shouldn't worry if the grizzlies of Wall Street occasionally claw your accounts.

You should also develop a diversified portfolio that will capture the greatest returns for the amount of risk you're willing to take. At a minimum, the typical long-term investor should own mutual funds that invest in large-cap domestic stocks, small-cap domestic stocks, foreign stocks and short-term or intermediate term bonds. That adds up to just four mutual funds, which shouldn't be too tough to manage.