Tuesday, June 17, 2008

Your Own Worst Enemy

Jim Parker, Regional Director, DFA Australia Limited, June 2008

It's a difficult pill for many of us to swallow, but sooner or later we need to realise that the biggest obstacle to enjoying investment success often is not the market itself, but our own behaviour.

This tough lesson about investment is never more important than in the volatile markets we have seen in the past year. It is at these times, more than any other, that people tend to make dumb mistakes.

Those mistakes include neglecting to diversify, failing to track expenses and ducking in and out of the market in counter-productive attempts to miss the worst of the losses and capture the sweet spot in the rebound.

The fact is that as fallible human beings we tend to over-rate our own abilities and imagine that we can see things that others can't. In an extremely competitive arena such as the financial markets, this can be ruinous.

Just how ruinous poor individual judgement can be to your financial health is revealed in a newly updated annual quantitative analysis of investor behaviour by the US financial services research group Dalbar.1

That latest survey, covering a two-decade period, echoed the findings of previous surveys—that returns are far more dependent on investor behaviour than on fund performance and that most fund investors who buy and hold typically earn higher returns than those who try to time the market.

In the 20 years to December 31, 2007, the average US equity fund investor would have earned an annualized return of just 4.48 per cent, Dalbar found. This was more than seven percentage points below the return of the S&P 500 index and less than 1.5 per cent over the inflation rate.

Fixed interest investors would have fared even worse. Their average annualized return over the same period was 1.55 per cent, below the index return of 7.56 per cent and not even keeping up with inflation. In other words, the average fixed interest investor went backwards over that time.

Dalbar concluded that investor returns are markedly different from the returns promoted by fund managers because most people try to time their entry and exit points—and often get it wrong. Secondly, the holding periods of individual investors tend to be shorter than those of fund managers.

Interestingly, the survey also found that investors are more likely to make 'correct' timing decisions when the market is going up. Correspondingly, they are more likely to mess things up when the market is down.

In other words, most people fail to exercise patience in tough markets. The consequence is they fail to secure the rewards available to them.

It seems that you really can be your own worst enemy.

1Quantitative Analysis of Investor Behaviour, 2008, Dalbar