Tradeless Nirvana

Market Trends and Investor Behavior

Tradeless Nirvana

It’s quiz time. I have devised the following test of “investment memory.” The period in question is the 30-year period 1970-1999. As you take this little quiz, keep in mind that the last 15 years have probably been among the greatest periods (if not the greatest period) ever for large cap stocks relative to small cap stocks. It has also been among the best periods ever for U.S. stocks relative to foreign stocks. In addition, the time period encompasses the 1990 collapse of the Japanese stock market, which has recovered little since.

So here is my test. Prioritize, in order of return, the following asset classes for the 30-year period 1970-1999:

  • S & P 500
  • DFA 9-10
  • UK small caps
  • Japanese small caps.

The answers are at the end of the story (no peeking please).

Behavioral economics is the study of human behavior and its impact on investment decisions. The results of studies produced by behavioral economists such as Terrance Odean help us understand the behavior of individuals and the mistakes they make. Financial economists debate the value of such studies in terms of any ability to provide insights into market prices and market rates of return. However, these studies can certainly provide insights into how we might improve investor (as opposed to market) returns - and there can be a tremendous difference between market returns and the returns achieved by investors.

Various studies have shown that one of the most common mistakes investors make is to chase yesterday’s returns. They watch a stock, mutual fund, or asset class provide superior returns for a period and then jump on the bandwagon. When the reverse holds true, and underperformance occurs, investors abandon ship. This type of behavior is called convex investing, since the pattern looks like an upside down V. It results in a buy high (at top of the upside down V), sell low (at bottom of the right side of the upside down V) investment cycle.

What investors should be doing is the reverse - concave investing, the right side up V. This results in a buy low (bottom of the V), sell high strategy (top of the right side of the V).Why do investors act in such a seemingly contradictory manner? The explanations might include:

1.) Greed. Investors see others achieving great returns in one sector or stock and simply can’t resist the urge to join in. They are often caught up in the noise and frenzy created by the media.

2.) Short memory. Investors tend to remember only the most recent data, as it is fresh in their minds. They are simply blinded by the superior performance of whatever is hot. They then project this data into the foreseeable future. This, of course, leads to buying what has already gone up.

3.) Lack of knowledge of financial history. Most investors don't understand how financial markets work, or the history of financial returns. This knowledge is necessary to make informed decisions. While financial economics is not a science, there is plenty of data - and logic - to support the view that periods of high returns are generally followed by periods of low returns. For example, investors who bought the S & P 500 Index when the P/E ratio was over 22 received returns of about 5% per annum over the next ten years. Those investors were obviously buying after a period of superior performance of large growth stocks.

On other hand, those investors that had the courage to buy these same stocks when no one else seemed to want them - when the P/E ratio was less than 10 - earned about 17% per annum over the next 10 years. Buy high due to low perception of risk - earn low returns. Buy low due to high perception of risk - earn high returns (1).

The latest manifestation of this behavior is the rush to own large-cap growth stocks. This behavior has been triggered by the spectacular returns of that asset class since 1995. For the period 1995-1999, the S & P 500 Index returned 28.6% per annum, outperforming the DFA 9-10 Small Company stock fund by 10.1% per annum. Even more eye-popping is its outperformance for the two-year period from 1997 to 1998. During this period, the S & P 500 Index outperformed the DFA 9-10 fund by over 24% per annum. For the three-year period from 1997 to 1999, the return difference is still almost 14% per annum. Even if we extend the period to 15 years, the S & P 500 outperformed the DFA 9-10 by 18.9% to 13.5% per annum.

Blinded by the light of this superior performance, investors rush in to buy large cap growth stocks and large cap growth funds. They often generate the cash to do so by selling those “obviously poorly-performing” small caps. By doing so, they are making the mistakes previously described.

Let's return to our little quiz. Here are the returns for the full 30-year period, probably among the best ever for U.S. large cap stocks:

  • UK small caps = 15.5%
  • Japanese small caps = 14.7%
  • S & P 500 = 13.7%
  • DFA 9-10 = 12.9%

As you can see, there was no great outperformance by U.S. large cap stocks. It is also worth noting that if we had ended our quiz in 1997 (28 years), the DFA 9-10 fund outperforms by 13.1% to 13.0%. Also keep in mind that in 1999 the DFA 9-10 outperformed the S & P by almost 9%.

Once again, investors chasing yesterday’s returns are paying for that behavioral mistake. The evidence shows that investors would produce far superior returns if they simply established an asset allocation plan and regularly rebalanced to restore any style drift caused by market movements. In addition to restoring the risk profile of a portfolio, this strategy has the added benefit of forcing investors to act in a convex manner, as they sell yesterday’s winners and buy yesterday’s losers. Isn’t that every investors dream, buying low and selling high?

(1). Fortune, August 16, 1999.