The experience of many ordinary investors during the 2008 global financial crisis provides a cautionary tale about the psychology of fund investing.
For those approaching retirement without the luxury of a comfortable, defined benefit pension, it must have been excruciating to watch pension pots evaporate week after week as the credit crunch worsened.
Fund flow data shows that in the first few months of 2009, a large number of people threw in the towel on shares, often shifting the bulk of their portfolios into cash or absolute return funds.
Since then, returns from these choices have not been disastrous, but are meagre and the timing could hardly have been worse. By capitulating when things looked the bleakest, many people essentially ‘sold low’ and not only locked in the worst of the losses on equities, but also missed out on the best years of the bull market that followed after the March 2009 bottom.
Financial crisis fallout
In the years since the crisis, many have watched with huge annoyance as their pension performance has considerably lagged recovering stock markets.
Put another way, the credit crunch created the perfect conditions for what is known as ‘investor behaviour penalty’. While market movements were obviously extreme during the crisis, research shows that fund investors tend to top up their holdings in the good times and cut back following periods of poor performance.
US-based research firm Dalbar, who has studied this phenomenon since 1994, reached a sobering conclusion: “No matter what the state of the mutual fund industry, boom or bust, investment results are more dependant on investor behaviour than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market.”
Key points
- Reaction to financial crisis led to many missing out good returns in the long term
- Investment results depend more on investor behaviour than on fund performance
- Pain-free market cannot continue forever
This can be illustrated with a simple example. Consider a fund that delivered a 15 per cent annualised return, after all fees and expenses, over a 10-year period compared with 12 per cent for its benchmark.
The manager would proudly highlight this market-beating outperformance of three percentage points a year in their promotional literature. And any clients who invested with the manager at the beginning and stayed the course for the full 10 years would be pleased with the outcome.
But life is not that simple. Very few people invest a lump sum and refrain from touching it for a decade. Even the most patient investors will usually have inflows, outflows and decisions made along the way. It is the timing of those decisions when the big mistakes are made – and they are often driven by emotions. In any given 10-year horizon, there will inevitably be periods of exciting returns and moments that are disappointing or even downright scary.
Behaviour penalty dangers
Of course, some investors make good decisions by buying low, but Dalbar’s work suggests that timing is typically poor on average. It is far more likely that the investors in our hypothetical example would experience a market-lagging 10 per cent return rather than the fund’s 15 per cent headline results.
To put this in perspective,a behaviour penalty of that magnitude (five percentage points) would result in the investor’s holding being worth 35 per cent less at the end of 10 years than what a simple buy- and-hold strategy would deliver. And that is for investors who were lucky enough to find an outperforming manager in the first place: If you combine an underperforming manager with poor investor behaviour, you have a real recipefor disaster.
Clearly, the behaviour penalty is not a good outcome for either fund managers or their clients, so why does it persist? Much of the blame rests with human nature. We are wired for survival and our instinct is to seek the comfort and safety of the herd. While this served our primitive ancestors extremely well, it unfortunately does us very little good as investors.
Although this is a timeless lesson, it is arguably even more critical for investors to understand at a time when many global markets are trading at elevated levels.
Markets have been remarkably pain-free in the years since the global financial crisis, but this cannot continue forever.
Many areas of the stock market look increasingly expensive, and we are likely to face an extraordinarily challenging investing environment in years to come.
Patience matters
We cannot predict the future, but it is safe to assume that we will all be tested. The behaviour penalty reminds us that our response might make the difference between success and failure.
We believe that one of the best things an investor can do is choose a manager who they believe in for the long term, be patient, and resist the temptation to make emotional decisions based on short-term results. As long as your interests are aligned with the manager, and the manager continues to do what you hired them to do, the results should take care of themselves.
Dan Brocklebank is head of UK at Orbis Investments
