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MAKING CENTS OUT OF THE NEWS
Blog #07
(February 18th, 2010)
HOW WE SABOTAGE OUR PORTFOLIOS
By Tom McAllister, CFP®
It's not new, by any means, and the wonder is, it keeps happening. Pathetic is the only way to describe investors' self-sabotage. Study after study has been completed on the behavior of individual investors, and the results don't change - the studies all indicate a tendency on the part of individual investors to “buy high and sell low” when they know perfectly well they should be trying to accomplish exactly the reverse. While annual stock market returns have averaged ten percent, individual investors have come away with far, far less, closer to three or four percent. For decades it's been the same story, as individual investors buy mutual funds near a market peak and then sell their shares near a market bottom.
The same tendency has been noted in retirement plan sponsors, foundation boards, and other institutional investors who are not investment professionals. One would expect them to be more sophisticated than individual investors, and in some ways they are. Nonetheless, when it comes to timing, institutional committees and boards tend to self-sabotage with the "best" of retail investors. With institutions, the major sin is the way in which they choose - and dismiss - investment managers.
Just like individual investors, these groups tend to “chase performance.” They hire money managers based on their performance records. Little or no attention is paid to the fact that money management techniques and strategies perform differently during different economic cycles. Often, institutional committees and board members become enamored of hedge funds based solely on high past performance, ignoring the fact that such funds often use leverage (borrowed money) to enhance performance, thereby sharply increasing the risk! Reaction to market dips and the ensuing disenchantment with a particular money manager causes the institutional groups to either lower the amount of money assigned to that manager, or discharge the manager altogether.
A recent study shows this type of portfolio value destruction tends to be more severe when plan sponsors remove all assets from a particular manager, as opposed to merely cutting back their commitment to that manager. The latter behavior resulted in a 1.12% underperformance. But performance is about twice as bad when a manager is completely fired, with results 2.17% lower than would have been the case if the fund had “stayed the course” with that particular manager. Changing horses midstream appears to work no better for institutions than for individual investments.
Look at it from the other side: You "fire" a manager or sell a fund because poor investment performance has caused your patience to run out. But what typically happens next is that the performance of that fired manager reverses itself as that manager's particular strategy comes back into favor.
If many are "dumping" a mutual fund, an exchange traded fund, or a manager, I'd suggest asking yourself, before following suit, if perhaps "everyone" isn't selling at the bottom. My advice to you is to be careful of choosing a fund, or a manager, based purely on recent past performance. Sound due diligence includes a look at the historical performance of the manager through one or more market cycles. That's because, over a longer time frame, most money manager results revert to the mean, while a select few outperform throughout entire market cycles.
Outstanding money managers whom I've observed perform approximately 4% better than the market indicator appropriate for their investment style, assuming no leveraging, just straight-up investing. Management fees, custodian fees and brokerage commissions (which should be independent of the manager) will siphon off two percent or so of these excess-over-market returns, leaving the investor ahead of the game by two percent. (Remember, these same expenses apply to the 80+% of funds and portfolio managers who do not outperform!)
No investor wants to hire a manager who has performed poorly. Paradoxically, though, it appears that in the interests of avoiding self sabotage, you might want to do exactly that! Consider this: Just because you think you are good at making decisions, doesn't mean you're making the right ones!
I remain available to share my insights gained from forty-eight years of experience in the investment business. No, I don't always know exactly how you should invest all your funds at any given point in time. But what I do know is many things you should not do! You might say Tom McAllister is in the Self-Sabotage Prevention business!
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