Investors their own worst enemy
Wednesday August 29, 6:00 am ET
Barbara Whelehan
Investors are likely reeling from the thrill rides provided by the stock market in recent weeks. Have you been tempted to jump off and wait for the "all clear" signal to climb back on?
Only problem is, where's that signal?
Fear and greed rule our behavior, and lately fear has been the dominant emotion. While fear causes us to sell and greed impels us to buy, the behavioral finance field offers more nuanced states of mind.
In reality, emotions shouldn't play a role in investment decisions at all. They cause us to lose in two ways: We incur trading costs when we buy and sell (and this activity could have tax ramifications, too). And then because we can't forecast precisely when the market will rebound, we miss out on potential gains.
Some emotions that thwart us:
Overconfidence (I was right!)
Optimism (I've got great market karma; few others do)
Regret (I wish I hadn't bought that stock ... )
Loss aversion (I won't sell and realize a loss because I can't admit I'm wrong)
Herding (I'll follow the crowd because millions of investors can't be wrong)
We should coolly and rationally make appropriate asset allocation decisions and continue to throw money at regular intervals into the funds we select, regardless of market moves.
Self-sabotaging syndrome
Nevertheless, market volatility causes investors to worry and move in and out of stock funds. Since 1984, the research firm Dalbar has tracked investors' mutual fund purchases and sales. In its 2007 Quantitative Analysis of Investor Behavior, Dalbar sees an improvement in investor fortitude, but observes: "Mutual fund investors who hold their investments are more successful than those that time the market."
It turns out that mutual fund managers can also be afflicted by neurotic investment behavior. "Even professional investors are prone to make poor trades when ingrained habits lead them astray," according to a recent MarketWatch article on behavioral finance that looks at the foibles of fund managers.
Don't go with the flow
In all fairness to fund managers, fickle investors flowing in and out of funds are partly to blame for many of the managers' poor trades. Gregory Kadlec, a featured speaker at the recent Morningstar investment conference, estimates that between 30 percent and 50 percent of all fund trades are operational in nature, "and the biggest culprit of these operational trades is shareholder flow."
For funds, trading costs run much higher when fund managers are forced to sell stocks immediately to meet redemptions. "If you're making a trade for purely operational reasons, it stands to reason that all of the costs are going to flow through to the bottom line," says Kadlec, a professor of finance in the Pamplin College of Business at Virginia Tech. Translation: Fund performance suffers.
Industry watchdogs have been muttering about fund trading costs for years. They're particularly pernicious because investors have no way of knowing how much their fund managers trade and how much the trades cost. Turnover is considered a barometer, but that can be misleading. "Turnover is a poor and unreliable proxy for a fund's actual trading costs," says Kadlec, who adds that existing studies on the relationship between performance and turnover show a positive or negative correlation, or no correlation at all.
The academic findings
Along with two other academics, Kadlec spent a year studying the impact of trading costs on mutual fund performance. The authors' main finding: Annual trading costs amount to 144 basis points on average, or 1.44 percentage points, for domestic equity funds. That's more than the average expense ratio of 1.21 percent, so trading costs can make a significant dent in performance.
"These 'invisible costs' include brokerage commissions, bid-ask spreads, price impact and timing costs," Kadlec says. Unlike fund fees, which are widely reported, these trading costs are very difficult to assess and are generally not reported, he says.
Kadlec and co-authors Roger Edelen and Richard Evans, the latter two from the Carroll School of Management at Boston College, studied 1,700 domestic equity funds from 1995 to 2006. They discovered that trading costs have a greater impact than expense ratio on fund performance, "because there's much more variation." On average, says Kadlec, every dollar spent on trading costs translates into a 42 cent reduction in fund value. So while funds recover half their trading costs, "the other half is a deadweight drag on fund performance."
The study looks at various types of trades among different types of funds, and goes into "excruciatingly boring details," Kadlec admits. He's right, so I'll spare you and get right to the punch line.
Says Kadlec, "You might conclude that all trading is detrimental to shareholder wealth, but that's not the case if you look deeper into this issue. The impact of trading on performance depends critically on who is trading and why. Large trades are particularly costly to performance ... By contrast, when funds trade in small quantities for discretionary purposes, the relationship between fund performance and trading costs is actually positive. Those funds actually more than recover their costs and add value."
It's not going to be easy to figure out which funds have the highest trading costs because turnover apparently isn't a good measure. But if you look at a fund's prospectus and quarterly reports, you can learn about the fund's investment strategy and style. If you're in a growth fund whose managers follow an earnings momentum strategy, it's a good bet that the fund will incur much higher trading costs than a fund with a buy-and-hold strategy.
The winning-est strategy
Buy-and-hold is arguably the best strategy for fund investors to have. A study in the June issue of T. Rowe Price Investor Magazine reveals the advantages of that strategy over market timing.
In a hypothetical example based on actual returns between June 30, 1990, and June 30, 2006, two people invest $100,000. Both portfolios were identically allocated in the beginning: 60 percent to large-cap stocks, 20 percent to small caps, 15 percent to international developed markets and 5 percent to emerging markets stocks -- all indexes which investors can't invest directly in, though they can invest in index funds with low costs.
The wimpy market timer bailed any time an asset class fell 10 percent within a month and invested that money in cash. Then when the asset class gained 10 percent within a month, the wimp summoned the courage to get back in.
Meanwhile, the buy-and-hold investor stuck with the same portfolio through bull and bear markets.
Guess who won? The market timer had average annual returns of 8 percent, and his portfolio grew to $342,600 . The buy-and-hold investor's annualized return was 10.3 percent, and his portfolio grew to $480,000.
Moral of the story: The markets may cause motion sickness at times. Just take some ginger and remember that over the long term, they inevitably will rebound. Longtime financial journalist Barbara Mlotek Whelehan earned a certificate of specialization in financial planning. If you have a comment or suggestion about this column, write to Boomer Bucks.
