It’s hard to keep count of all of the studies that show how humans make very poor, money-losing investment decisions.
In a new post for Credit Suisse’s website, strategist Michael Mauboussin explains some of why this is so.
“One behaviour of investors that is well documented is the tendency to buy after the market has risen and to sell following a drop,” wrote Mauboussin.
He included this chart, which shows the results of this behaviour.
“On average, investors earn 1.5 percentage points less per year than a buy-and-hold strategy as a result of the dumb money effect,” noted Mauboussin. “So our minds encourage us to act at extremes and buy when the market is up and sell when the market is down.”
Buy-and-hold returns (aka time-weighted returns) represent what happens when an investor just buys and holds. Asset-weighted returns capture investors buying when prices are high and selling when prices are low; a money losing exercise.
Mauboussin walks us through an example:
Here’s a simple illustration. Let us say an investor buys 100 shares of a fund that starts a year with a net asset value of 10 US dollars, representing an outlay of 1,000 US dollars. In the next year, the fund’s net asset value rises to 20 US dollars, doubling the investor’s money. Excited, the investor buys an additional 100 shares, spending another 2,000 US dollars. In the second year, the net asset value of the fund declines to 10 US dollars, back where it started. How did the fund and our investor fare over the two years? The time-weighted return for the fund is zero, of course, as the fund ended at the same price as it started. But the asset weighted return for the investor is — 27 per cent , calculated as the internal rate of return based on the timing and magnitude of the investor’s cash flows. The return would have been zero had our investor used a simple buy-and-hold strategy, and there would have been no nominal gain or loss. But in the scenario we outlined, our investor lost 1,000 US dollars of the 3,000 US dollars total investment because of the purchase after the fund rose.
“Because of investor behaviour, returns for major indices substantially overstate the returns that investors actually earn,” he wrote
“Investors can counterbalance this tendency by making predictions that place more weight on past results and less on recent outcomes.”