Investors Continue to Be Their Own Worst Enemy

Investors Continue to Be Their Own Worst Enemy

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Investors Continue to Be Their Own Worst Enemy
"The investor's chief problem—and even his worst enemy—is likely to be himself." – Benjamin Graham

A topic we have addressed on many different occasions is poor investor behavior and its deleterious impact on their returns. A recent article in Morningstar Advisor by Russell Kinnel, Why Investors Lag the Returns of Their Funds, brings further quantitative evidence of this problem. Specifically, he found that the difference between the returns reported by the mutual funds (the time-weighted returns) exceeded the returns achieved by investors as a whole (the dollar-weighted returns) by an average of about 1% per year over the ten years ending 12/31/2012 across all asset classes and U.S. equities. Kinnel refers to this difference as the “behavior gap” because it is largely attributable to poor timing of investor cash flows such as buying after a fund has had good returns and selling after a period of poor returns.

The asset class with the largest behavior gap was international equity funds where investors lagged their funds by 3.1% per year. In looking at the historical returns of the most widely used index of international equities (MSCI EAFE) compared to the S&P 500 Index (which many U.S. investors would use as a comparison benchmark, albeit incorrectly), it is easy to understand how this disaster unfolded. In the first five calendar years of the period (2003 to 2007), the EAFE Index beat the S&P 500 Index in all five years by an average of 9.3% per year. No doubt, a large chunk of investor money was poured into those funds after the high returns took place. Naturally, the subsequent five calendar years (2008 to 2012) proved to be a disappointment, as the EAFE Index lagged the S&P 500 by an average of 3.8% per year.

An examination of the behavior gap for certain actively managed funds reveals just how destructive poor investor behavior can be. Our favorite example is the CGM Focus Fund (CGMFX) in which investors lost money even though the fund had a positive return over the whole period, as illustrated in the chart below:

The Fairholme Fund (FAIRX) provides a less extreme but still quite relevant example. You may recall that the manager of this fund, Bruce Berkowitz was named Morningstar’s “Fund Manager of the Decade” in 2010. This may have been the kiss of death, as Fairholme1 lost 32.4% in 2011 while the S&P 500 Index gained 2.1%. Investors who poured in over $4 billion after Morningstar’s announcement received a rude awakening. The most recent numbers from Morningstar (as of 4/30/2013) tell an ugly story of investors receiving an annualized return of 3.77% over the last ten years while the fund reported an 11.37% return. In other words, the investors captured only one-third of the annualized return of the fund.

One of the most effective counter-measures against falling victim to emotionally-based investment decision-making is to hire a passive investment advisor who can keep your investment plan on track, regardless of what happens in the financial markets. If you wish to learn more about the advantages of working with a true wealth fiduciary, please feel free to drop us a line at [email protected] or call us at 888-643-3133.

 

"We have met the enemy and he is us" – Pogo

1All numbers related to the Fairholme fund are from Morningstar Direct and Morningstar.com.