1 Simple Chart to Explain Why We’re So Bad at Investing

On more than a handful of occasions, I’ve written about investors’ propensity to buy and sell at exactly the wrong times (i.e. investors tend to buy high, and then sell low). And, I’m so engaged in this issue because bad investing behaviour in buying and selling (as opposed to investing based on bad research or analysis) is often one of the main reasons that cause investors to earn poor returns.

My latest article touching on the topic was published exactly a week ago titled “Don’t Blame Money Managers Solely For Losses – Look At Yourself Too”.

In it, I shared the experience that legendary US fund manager Bill Miller (Miller became a legend when he beat the S&P 500 in every single year between 1990 and 2005) had with his funds’ investors. He was frustrated with how his investors often ended up buying high and selling low and even shared how one of his investors had pulled out all his funds in 2008 despite knowing that it was one of the worst possible times to do so.

Earlier today, I found a pictorial representation of what Bill Miller had experienced with his investors, but on a much broader scale. And since you know what they say about how pictures can represent a thousand words, here it is, courtesy of the Federal Reserve Bank of St. Louis’ blog:

Source: Blog post at the Federal Reserve Bank of St. Louis; data source from Investment Company Institute

It’s intuitively clear from the chart how investors had been chasing performance – increasing their purchases when things look rosy, and then pulling out of their investments en masse when things turn south. According to the blog post, the “correlation coefficient between the [funds’] returns and flows was 0.49.”

Such systemic return-chasing behaviour from investors can be very costly. For instance, the fine folks at the St. Louis Fed found that “chasing returns caused the average U.S. mutual fund investor to miss around 2 percent return per year, which is very significant.” There have also been many other such studies conducted. One of my favourites (it’s a favourite of mine because it highlights acutely the magnitude of the problem) was recounted in my article that I referenced earlier:

“David Swensen, the chief investment officer of Yale University’s US$20.8 billion (as of 30 June 2013) endowment fund and one of the best in the business, once gave a guest lecture in 2008. In it, he mentioned a study conducted by investment research outfit Morningstar. What the study found was stunning: Morningstar categorised equity mutual funds in the USA into 17 categories and found that over a 10 year period, all categories saw the average mutual fund investor dramatically underperform his or her own funds’ results (sometimes by as much as 13.4% per annum!).

And that happened, as Swensen said,because the investors “had bought after the funds had gone up, and they sold after the funds had gone down.” In other words, investors had been buying high and selling low.”

There could be many different reasons why investors engage in such behaviour but for those who do so thinking they can outsmart the market, please don’t do that again! The odds would likely never ever be in your favour if you’re trying to correctly guess the tops and bottoms of the market.

Marc Faber, a prominent investor and publisher of a financial newsletter, has suffered badly over the past few years trying to predict possible collapses in the US share market. Even the best and brightest of Wall Street (the financial centre of the USA) can’t tell what the markets can do over the short-term; the following set of data, as collated by my American colleague Morgan Housel, shows it clearly:

Analyst / Institution Forecast for where the Dow* would end in 2008
William Greiner / UMB Financial 14,400
Tobais Levkovich / Citigroup 15,100
Bernie Schaeffer / Schaeffer’s Investment Research 15,300
Leo Grohowski / BNY Mellon Wealth Management 14,800
Thomas McManus / Banc of America Securities 14,700
David Bianco / UBS Investment Research 15,250
Actual S&P 500 Close: 8776
* The Dow refers to the Dow Jones Industrial Average, one of the oldest US share market indices.

In any case, regardless of the causes for investors’ tendency to buy and sell at the wrong times, here’s something we at The Motley Fool Singapore have written about which might help mitigate the problem somewhat:

 “Don’t try to calculate when you should buy stocks. It’s too complicated a problem with too many unknown variables. Instead, dollar-cost average, buying the same amount of stocks every month or every quarter, rain or shine. Over time you will beat almost everyone who doesn’t follow this approach.

Don’t try to calculate what the market might return over the next year or two. You’ll never figure it out. Instead, assume it’ll return 7%-8% a year over a multidecade period – with a lot of volatility in between – because that’s what it has done in the past (the Straits Times Index (SGX: ^STI) has a compounded annualised return of 5.26% since the start of 1988 to its current level of 3,282 points; throw in 2%-3% of dividends per annum and you end up with a return of 7%-8% a year).”

Foolish Bottom Line

Even the best investing tips can’t do much for an investor’s returns if he can’t save himself from his own poor investing behaviour. So, instead of thinking about where the best investment ideas can be found now, we might all want to consider (I certainly do that all the time!) how we can adjust our own investing behaviour first.

As portfolio manager and author Patrick O’Shaughnessy recently wrote, “Now that investing is almost free [referring to the very low costs and effort it takes for investors to invest], this is the final frontier: how to effectively protect investors from themselves.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.