Investing: Short Term Anxiety vs. Long Term Strategy

It's human nature for to get a little nervous in the face of short term losses. Decisions made emotionally or with impulse often result in regret. With the volatility we're currently experiencing in the market it is important to contact your financial advisor to get a sense of your big picture strategy.

Performance in the short term can cause anxiety, but looking at short-term performance vs. long-term performance of the same index can bring more clarity. One year is an optimistic holding term for most investors in calm times; in more volatile markets emotional horizons can be even shorter.

A short-term evaluation period can be hazardous to your wealth. One way people make themselves comfortable during a volatile market is by trading excessively to “take advantage” of perceived patterns in the market. While some activity must take place in a portfolio (rebalancing asset classes, buying undervalued/selling overvalued positions), frequent trading is often a response to random market movements when in actuality the risk-return aspects of the asset hasn’t changed. The short-term emotional component of these decisions tends to lead people to take more risk when they are comfortable and reducing it when they aren’t. In other words, buying high and selling low.

For example, one study placed investors into five groups based on their portfolio turnover. The lowest turnover group turned over less than 1% of their portfolio each month while the highest turnover group turned over nearly 25% of their portfolio each month. One would think that the more active investors would outperform as the activity would move them out of less desirable investments into more attractive ones. In fact, the opposite was true, with the less active investors significantly outperforming their more active counterparts [2].

DALBAR (a company that provides analysis and evaluation of businesses, products, and customers in the financial industry) releases an annual Quantitative Analysis of Investor Behavior (QAIB) report, which captures individual investor behavior and compares it to an institutional approach. Since 1994 the QAIB report has measured the effects of investor decisions to switch into and out of mutual funds over short and long-term timeframes. Through this analysis, the QAIB has shown that investment results are more dependent on investor behavior than fund performance.

Their most recent report covered the period from January 1, 1988 to December 31, 2017 and utilized mutual fund sales, redemptions and exchanges each month as the measure of investment behavior. Based on this behavior, they computed “average investor return” and compared those returns to those of their respective industries. The following page contains a summary of important findings in the report[3]:

• In 2017, the average equity mutual fund investor underperformed the S&P 500 by a margin of 1.19%. (20.64% vs. 21.83%)
• Two of the three best performing months for the S&P 500 (October and November) coincided with relatively large net outflows of assets
• The average mutual fund investor did not stay invested for a long enough period to execute a successful long term strategy. There were numerous instances in which market conditions created a shift in cash flows opposite to the eventual direction of the market

The findings from DALBAR demonstrate the inability for investors to have a long-term investment perspective. 2017 was a very strong year for the market and yet mutual fund investors on average still underperformed the market. Given the counter-productive actions of these fund managers, it’s clear that many of them were fearful and cautious of the current market conditions. In the graph on page 10, you can see the average equity fund investor was on the verge of outperforming the market over a 12 month period for the first time since 2009[3]. 

As mentioned, there was a relatively large shift out of equity positions in the fourth quarter, which was ultimately some of the best performing months of the year. This indicates that many investors were in the pessimism stage, feeling that after 3 quarters of solid gain that the market was due for a correction or downturn. It is this kind of short-term investment rationality rather than some unforeseen market events that consistently diminish investor returns.

In a 2014 study by Federal Reserve Senior Economist YiLi Chien, he looked at the correlation between U.S. equity mutual fund flows from 2000 to 2012. It is easily apparent that U.S. equity mutual fund flows are positively correlated with their past returns (correlation coefficient of 0.49)[2]. This indicates return chasing behavior. 

The emotional response to poor performance in a mutual fund is to pull your money out and put it in a fund that has had a positive performance on the year. This leads to return chasing, and given that stock markets are nearly impossible to predict in the short run and reverts back to the mean in the long run, the tendency to buy high and sell low when chasing returns will reduce profits.

Emotions in investing can lead to poor analysis and decision making as well as performance chasing. To correct these natural tendencies, investors need to develop a long term view when investing. Another option is to hire an intermediary who will put their emotions into perspective and help them remain invested during market turbulence.

The goal for investors is to get away from this short term thinking and view sectors of the market as either under or overvalued relative to long-term industry averages. Looking at current trends isn’t a bad thing per se, but making frequent trades based on these trends is where many investors go wrong. Having a trusted financial advisor, who acts as a level-headed voice of reason can be an important asset when investing.

For more information reach us at https://techstaffer.blog/

Sources:

• The Retirement Group or www.theretirementgroup.com
• https://www.barclayswealthportal.com/en_gb/home/research/research-centre/white-pape%20rs/Behavioural-Finance/Cycle-of-investor-emotions.html
• https://www.aag.co.uk/news/even-keel/
• https://content.swanglobalinvestments.com/hubfs/Third%20Party%20Documents/Dalbar%202018%20QAIB%20Report%20-%20Quantitative%20Analysis%20of%20Investor%20Behavior%20-%20Advisor%20Edition.pdf