Clients who avoid letting greed or fear dictate their investment decisions almost always outperform their market-timing peers. Such were the findings of a 2007 Quantitative Investment Behaviour Study (QAIB) of U.S. investors by DALBAR Canada.

Jody Bullen, spokesperson from DALBAR Canada, says the performance gap exists solely because emotions and human influence often cloud investing judgment. Those investors who turn over their holdings frequently in a quest to outperform the market on a quarter-to-quarter basis rarely outperform those with disciplined long-term investment strategies.

DALBAR found that the average retail mutual fund investor grew a $10,000 investment to only $21,422 between 1987 and 2005, while a buy-and-hold investor using the S&P 500 index grew that same $10,000 into $94,555.

According to the study, investors guess right 75% of the time in picking sound investment choices during a market upswing but less than 50% of the time during a market drop.

This could be because in a downturn, good picks are hard to come by. DALBAR says behavioural factors play a pivotal role in poorly timed sell-offs. Fear heightens the investor “herd mentality,” which will force investors to make decisions that are often against their better judgment. They tend to react impulsively if they are barraged with bad news from the media, and DALBAR says they often copy the behaviour of others even in the face of unfavourable outcomes.

Lisa Kramer, associate professor of finance at the University of Toronto’s Rotman School of Management, says psychology is playing an increasing role in understanding investment performance.

“We’re recognizing that the financial decisions people make are at least partly influenced by human nature,” says Kramer. “Everything we see in financial markets is the sum of the parts, so we’re starting to think more deeply about what investors and fund managers are doing.”

She notes that pride can play a big role in the underperformance of investors.

“Many investors are driven by a need to feel good about their decisions, and so people often make financial decisions that confirm they’re smart,” she says. “If someone holds a basket of stocks, some have performed well over the holding horizon and some have performed poorly. If for liquidity reasons they must sell stock, they’ll be much more likely to sell the stocks that perform well.”

This would seem like a case of sell high and buy low, but Kramer says investors will do this, even if there is something to be gained through selling the poor stocks, such as taking advantage of the capital losses. They’ll abandon the bigger investment picture to make themselves feel better about their stock picking ability.

“It’s sort of an ego thing. You get to feel good about the stock that you’ve done so well on, and you can forget about the stocks that haven’t,” Kramer says.

Kramer also notes that, even armed with these types of insights into investor behaviour, it’s still extremely difficult to account for market trends, so she agrees with the buy and hold approach the QAIB study advocates, particularly for individual investors.

“When you see things going crazy in the market and you have this urge to sell, it likely makes sense to hold your breath and tie your hands behind your back and adopt a true buy-and-hold strategy, rather than trying to time the market,” she says.

Another highlight from the QAIB study is the impact dollar-cost averaging can have on investment performance.

Dollar-cost averaging will greatly reduce the earnings potential vis-à-vis a lump sum, but it also provides stronger downside protection. According to the study, it also greatly outperforms lump-sum investing over the long term.

The average investor has realized a return of $23,252 on an initial $10,000 lump sum investment over the past 20 years. If the same investor had made the same investment decisions, but used dollar-cost averaging to make $10,000 in contributions, DALBAR says, the investor would realize a return of $32,877, representing an additional gain of $9,625 or 40% over the same 20-year period.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(09/04/07)