The Investor Returns Gap and the Value of Disciplined Management
Jordan Edwards | June 13, 2016
“The investor’s chief problem—and even his worst enemy—is likely to be himself.” Benjamin Graham
As investors, we face many challenges in the process of properly valuing investments. We have the assistance of numerous analytical models which do a wonderful job discounting future cash flows and deriving the value of a security given certain growth assumptions. If we only knew with certainty what growth will materialize in the future, we could value any investment without worry.
However, as we all know, the future remains uncertain. This has important implications for investing, especially when coupled with human proclivity towards recency bias. Recency bias is the tendency to think trends and patterns we observe in the recent past will continue into the future. When markets have been down in the recent past, investors tend to extrapolate that going forward and become pessimistic about future market returns. This pattern persists despite the mathematical certainty that after a draw-down, forward-looking returns increase on a relative basis. Similarly, when the domestic stock market performs better than international stocks, human nature pushes us to expect domestic dominance to continue ad infinitum.
Unfortunately, if left unchecked, recency bias can cause investors to make exactly the wrong decision—often at the worst possible time. Rather than taking the time to understand which exposures led to their performance over the recent past, many investors will abandon funds or strategies that have underperformed in favor of those funds and strategies that have outperformed. In effect, these investors are selling low and buying high. This is a problem not only for do-it-yourself investors, but also many financial advisors are guilty of chasing “hot” sectors or asset classes.
This pattern of behavior can be quantified by identifying whether changing strategies results in a net positive or net negative to the end investor on average. We can look at the difference between a fund’s time-weighted return (returns which are unaffected by cash flows into and out of a fund) and its money-weighted return (returns which are affected by cash flows) to identify whether shareholders on average benefit from their investment timing choices or are harmed by such behavior.
As we see in the above chart from Research Affiliates, time-weighted returns outpaced money-weighted returns for all categories during the timeframe studied. The blue bars illustrate the return generated by the underlying asset class, and the gray bars illustrate the returns investors experienced within those same asset classes over the same time period. This means the underlying mutual funds did better than what the average fund investor realized (and in some cases a lot better). How could this be?
The answer is fund investors and financial advisors attempting to beat markets through active management tend to enter a fund right after a period of outperformance, and exit a fund right after a period of underperformance. This is recency bias rearing its ugly head. People assume because a fund is doing well, it will continue to do well. Conversely, people assume a fund that has recently performed poorly will continue to underperform. Another way to quantify this is to look at funds that have the highest inflows compared to funds with the lowest inflows. If investors and active managers were doing a “good job” picking funds, you would expect the funds with the highest inflows to do the best going forward. However, in the following chart we see the exact opposite.
This chart divides mutual funds into quintiles ranked by how much money is flowing into them, and then quantifies returns experienced by those funds after the fact. As you see, from 1980-2003, the funds attracting the most new money did the worst, whereas the funds with the least new money did the best. This performance chasing inevitably leads to long-term underperformance, which in turn leads investors to abandon their current strategy or advisor and repeat the process all over again.
Vanguard and Morningstar have produced similar studies and have reached the same conclusion: investors tend to cause more harm than good to their portfolios with their timing decisions. This is due to both indiscriminate selling during periods of severe market distress, as well as selling funds with recent underperformance in favor of funds with recent outperformance.
Basing investment decisions on emotional inputs results in herding behavior. Expensive assets get more expensive as investors herd into them while cheap assets get cheaper as investors rush out the door. Oftentimes, fear of losing clients will cause undisciplined, active managers to do the same thing. Over the short-term, it can be emotionally pacifying to sell the funds which have done poorly in favor of what’s “hot” today. Even though this approach likely harms the client’s long-term return, many advisors are more interested in pacifying the client over the short-term than sticking with their strategic allocation. This further contributes to expensive assets getting more expensive while cheap assets get cheaper.
However, eventually the pendulum stops and starts to swing in the other direction. A disciplined, systematic plan to rebalance portfolios over time helps counteract the emotional desire to buy funds that have recently performed well. Instead, the investor sells assets with recent outperformance and buys those assets that have not performed as well. This systematic approach to investing can significantly boost returns and help investors make better decisions about where to allocate capital.
At Avier, we recognize the problem of performance chasing and are committed to making sure our long-term strategic allocations are indeed long-term. We understand the importance of maintaining discipline even in the face of short-term market volatility. Even though it is never easy to accomplish, we all must work to take emotions out of our investment decisions. Whether an individual investor or a professional money manager, it is important to be aware of recency bias and take a disciplined approach to overcome it.