The Cost of fear and greed


“People don’t need extraordinary insight or intelligence. What they need is the character to adopt simple rules and stick to them.” Benjamin Graham mentor to Warren Buffet.

Two recent studies from the US underscore the importance of discipline and long-term focus in investing. One is by Morningstar, the mutual fund rating company, the other by Dalbar, a research firm.

Each examines investor behavior by studying mutual funds, but the implications are much broader.

Reported mutual fund results assume a fixed amount invested over a period of time. But, in fact, more money tends to flow into funds after periods of the best performances so that the average invested dollar (and hence, the average investor) tends to perform worse than the average fund. The Morningstar study confirmed this, finding that because of investor activity over the past 10 years, owners of diversified US stock funds experienced a pre-tax "dollar weighted" return 1.5% per year less than that of the funds net published results.

The Dalbar study focused on the same issue using data from the Investment Company Institute.

They found that over the past 20 years through to the end of 2009 the average equity fund investor earned an annual average return of just 1.87% compared to the average annual return of 8.42%pa for the S&P 500 over the same period.

Both studies confirmed that investor behavior is the largest destroyer of investment returns. The problem is activity - in other words, short-term focus and lack of discipline. The drivers of activity are often fear and greed.

Greed manifests itself in the temptation to chase hot investments, hot funds, stocks, sectors, or asset classes, and in doing so, to ignore diversification. "XYZ is soaring. I need some of that, too." The sickness is greed and the antidote is broad diversification and disciplined asset allocation, which includes rebalancing back to a target asset allocation designed specifically to match the investor’s personal goals, objectives and risk capacity.

Fear manifests itself in the desire to sell risky assets and sell out to cash in response to a crisis also known as market timing. In this case, the disease is fear, but the remedy is exactly the same - diversification and rebalancing. As financial writer, Nick Murray, wrote in a recent addition of Financial Advisor magazine, "Going to cash in reaction to shocking events is not merely different from lifetime goal focused investing, it is the opposite. Indeed, the mortal enemy of good investing."

Those gripped by fear often assert that "it's different this time”, and, of course, it is since each crisis is in some ways unique. Murray pointed out the same could have been and has been said of any recent news story.

Equally today's headlines are filled with concerns we could lose sleep over.

News networks assure that each crisis is vividly portrayed - feeding fear, while the business channels constantly remind us of the returns we missed by not holding enough of this or that hot investment - fueling greed. In contrast, the studies cited above remind us of the terrible cost of those two demons - fear and greed - and the enormous benefit that can accrue from simple discipline and a long-term focus.

“Financial decision-making is not necessarily about money,” says psychologist Daniel Kahneman at Princeton University. “It’s also about intangible motives like avoiding regret or achieving pride.”

An article in 2005 by Don Phillips, Managing Director of Morningstar, Inc., highlighted the benefits of index fund investing. At GoldCore, we are also proponents of this style of investing due in part to lower costs, greater trading efficiencies, and the precision of a consistently-applied approach. Indeed, index investments are becoming a hugely popular choice among both professional and individual investors. According to Mr. Phillips, “On the whole, indexing has served investors well, but there's a dark side to indexing that investors shouldn't ignore. Consider that over the past decade, the dollar-weighted return (the return investors received based on when they purchased and sold shares) of all index funds was just 79% of the time-weighted return (the return of the fund) investors could have received with those funds.”

Mr. Phillips continues by reviewing the performance of investors in funds managed by Dimensional Fund Advisors (a money manager we recommend). He concludes that the investor returns for Dimensional Fund shareholders are much better than the typical no-load index fund investor. In fact, “the dollar-weighted returns of DFA funds over the ten years (ending December 2005) are actually higher than their time-weighted returns, suggesting that the advisors who recommend DFA funds encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up rather than buying at the peak and riding the trend down, which is usually the case with fund investors.”

We believe that both of these research articles offer considerable third party validation that our disciplined philosophy and use of institutional funds such as Dimensional Fund Advisors is a fundamentally sound method to deliver “valued added” investment returns.

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