The Cost of Emotional Investing
When it comes to asset allocation, the topic of emotional investing – or more specifically, why you should keep emotions out of investment decisions – is usually broached when markets are volatile. However, even with the relative calm in markets since 2012, sentiment can still drive investor behaviour.
To illustrate, we refer to the recent performance of US Equity funds, which stand head and shoulders above the rest. The median return for US Equity mutual funds in the GlobeAdvisor database is 25.44% ($CAD) over the past year to June 30th. This is almost double the 12.88% return for Canadian Equity funds and trounces the 0.93% loss for the average Canadian Fixed Income fund. Thus far in 2013, it seems the more diversified your portfolio was, the worse it did, with Emerging Market funds, High Yield bonds and popular gold ETFs also posting weaker returns.
Given these wide return disparities, some may question whether their long-term asset allocation is appropriate. For these investors, it may be instructive to consider the recency bias, a behavioural reaction where only the latest performance figures are considered when forecasting future results. Evidence of this effect can be seen in comparisons of dollar-weighted versus time-weighted returns. Time-weighted figures are the ones that are normally presented in fund fact sheets. However, dollar-weighted stats also consider cash flows, placing more emphasis on returns in periods after large investor inflows.
In June 2012, our commentary touched on the fact that emotions often impede successful, long-term investment success. As is frequently the case, investors have the uncanny ability to “buy high and sell low” when they chase returns of the asset class du jour. The graph above attempts to show the potential costs of this emotional investing, showing the performance drag that results from trying to time the market. A recent report from Dalbar, an investment research firm, used a dollar-weighted methodology to compare the annualized returns of the average US investor to the broad indices. They found that the actual return received by the average investor trailed the benchmarks in all cases. While fees accounted for some of the performance gap, they estimated that psychological factors explained some 45% to 55%. With the average investor holding funds for less than three-and-a-half years before switching, excessive trading and poor market timing eroded any value that active management could have added. With this in mind, it is important to note that the results were for the average US investor. The study concluded that the few who followed a “buy and hold” strategy did in fact perform much better over the time.
As alluring as the potential gains from timing markets may sound, the long-term results are often disappointing. Ultimately, the future is unknown and short-term movements of indices are quite random in nature. You can’t control the markets, but you can control your investment plan. At T.E. Wealth, we work diligently to construct a portfolio that takes into consideration your risk and return objectives as well as any unique constraints. While we believe that long-term, buy-and-hold strategies are optimal, this should not be confused with a “set it and forget it” approach. As markets move, opportunities to rebalance portfolios into undervalued asset classes present themselves. Whereas the average emotional investor often mistimes trades and large portfolio shifts, rebalancing helps to ensure that we “buy low and sell high” regardless of recent performance or volatility swings.
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