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Protection From The Person In The Mirror

No matter how many times I see the results, they astound me. DALBAR, a mutual fund research firm, has been conducting an ongoing study that compares the following:

  1. Investment returns experienced by individual mutual fund investors.
  2. Investment returns of the actual mutual funds.

DALBAR Study Results [chart]One would think that there wouldn’t be much difference between the results of mutual funds and the individuals who invest in them, right? Yet there has consistently been a shockingly large disparity. Between 1984 and 2002, the average stock mutual fund returned 9.6% a year. But the individual investing in stock mutual funds saw a return of only 2.7%. How can this be?

The short answer is that fear and greed lead us to disregard our ability to reason. It could be described as a form of temporary insanity. When the outlook is bleak (often following market declines) we sell when we should be buying or adding to our holdings. When the outlook is positive (often following market increases) we buy when we should be selling or reducing our holdings. By the time we recover our senses, the damage has been done.

How can we protect ourselves from these poor decisions? First, let’s explore what is behind our actions. Behavioral finance studies look at the way people make financial decisions. These studies have demonstrated that investors generally:

  • Are overconfident, believing they are better at making choices than they really are.
  • Overreact to both good and bad news.
  • Believe in winning streaks and are impressed by short-term success.
  • Confuse familiarity with real knowledge.
  • Easily lose long-term perspective and believe that what has occurred recently will continue indefinitely.
  • Get trapped in a cycle of fear and greed. (For example, when the investment markets go up, they want to rake in as much as possible. When they fall, they fear there will be no end to the decline and all will be lost.)

Mutual fund and other financial services companies are well aware of our individual weaknesses. Many companies capitalize on the knowledge of our behavioral tendencies by creating advertisements that play to our vulnerabilities. Advertisements are created that highlight investments which have recently performed exceptionally well. Our response is to sell out of our current investments, which at the time have lower returns, and purchase the advertised high performer.

During 1999 and early 2000, personal finance magazines and newspapers were filled with advertisements highlighting stock mutual funds with recent returns in excess of 40%. In contrast, the returns from bond mutual funds during 1999 generally ranged from -3% to 3%. As a result, individual investors responded by selling billions of dollars from their bond funds to purchase the advertised funds (primarily growth stock mutual funds with high exposure to the technology sector). The majority of investors’ money went into these growth funds after the high returns. The period of the next three years saw a dramatic swing in the markets with growth stock funds experiencing major declines while bond funds had solid positive returns.

The result: the majority of investors bought into the stock funds at high prices in late 1999 and early 2000, enticed by their recent performance. As a whole, they missed out on the majority of the increasing prices but participated fully in the steep decline that followed.

The electronic media also plays to our weaknesses with daily “advice” on what’s hot and what’s not; projecting what’s going to happen today and trying to explain what happened yesterday. This constant barrage of advice and predictions creates a sense of urgency for many investors, making them feel that they need to take action or they will miss out. These decisions, based on emotions and often influenced by the media, have had devastating results as seen in the DALBAR study.

The lingering question is: how can we protect ourselves from these irrational decisions? We recommend three steps:

  1. Acknowledge the issue. We are emotional beings and have a tendency of making poor financial decisions when we are in an emotional state.
  2. Adopt a carefully constructed investment strategy that is appropriate for your situation and is aligned with your willingness and ability to accept periodic declines in the value of your portfolio. This strategy should define the circumstances under which you would be willing to consider changes to your investments.
  3. Before executing any major changes, step back and perform a rational analysis of the situation. Consult with a knowledgeable and trusted advisor who may be able to provide a detached point of view on the situation.

At Merchants Trust Company, one of our most important roles is assisting our clients in making wise financial decisions. Our investment process offers protection from decisions that are harmful to our clients’ financial health. This disciplined process ensures that thoughtful, rational analysis and extensive due diligence is part of every decision and emotions are reserved for all of those other important areas of our lives.

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