The Cost of Emotional Investing

by: Bryan Keller

Forget what the college economics textbooks teach you -- individuals are emotional and irrational.

Sure, in the theoretical Guns and Butter (or, for the hip new-school textbooks which try to build "street cred" with students: Beer and Pizza) world, there's a rational trade-off, supported by thoroughly structured and emotionally detached reasoning and rationale. But in our world, which we'll refer to as "reality", there is one additional and important variable to add to the equation: Emotion. And one additional and important variable to subtract from the equation: Rationality.

One common thread amongst humans is our ability to rationalize our actions, despite the known consequences that are derived from the decision. Children, for instance, subversively rationalize against turning off the lights, making their beds, shutting the refrigerator door, doing their homework, and taking their shoes off before they enter the house. They know (at least subconsciously) under each circumstance that there is a penalty for doing -- or not doing -- each of these actions, yet still they choose to proceed.

As we age, the specific behaviors may change (think back to your college days, for example), but the premise remains. Today we've all gotten much better at turning off the lights and shutting the refrigerator door (amazing what happens when you have to pay the bills!), yet the data is overwhelming that within the realm of one of the more significant and impactful decisions we make in our lifetimes -- specifically the act of saving and investing for retirement -- we humans, as "investors", have yet to assemble the requisite habits, characteristics, and behaviors to do so successfully.

The irrational line of thought which espouses an individual's "rational behavior" has also managed to extend itself into the world of investing. And guess what -- irrationality is costing investors money. So let's analyze how irrational and emotionally influenced behaviors are detrimentally affecting the performance and outcome of retirement savings.

There are many means by which to demonstrate this faulty behavior -- an investor who chases performance, one whose portfolio is not properly balanced and diversified, one whose portfolio is overly concentrated, or an elderly couple nearing retirement whose savings are 100% in stocks.

Yet, if there's one data point that fully and completely captures each of these subliminal mistakes as listed above, and which aggregates the result into a measurable output, it would be the actual returns that individual investors are achieving on their investments. Regretfully, there's a difference between an investor's actual return, and the return of the product or vehicle in which that individual is invested.

To more intensely examine this concept, we'll be utilizing the Morningstar Investor Return data series to illustrate our findings, which states:

Investor's return measures the experience of the average investor in a (mutual) fund. It is not one specific investor's experience, but rather a measure of the return earned collectively by all the investors in the fund. Investor returns are not a substitute for total returns but can be used in combination with total returns.

Just looking at how your mutual fund performed over the one, three and five year or more periods is probably not the best way to gauge what your actual performance was. The impact of cash contributions and withdrawals would have varying degrees of impact on your actual performance depending on the size (as a percentage of your original position) and timing of the said contribution or withdrawal. Regretfully for most of us, it is emotion that drives the timing of those contributions, and usually it is to the detriment of performance.

The concept of emotionally and momentum driven investment decision making takes a more interesting turn when you begin introducing the above mentioned Morningstar Investor Return numbers. Here, the introduction of differing asset classes as well as sector, style, regional and thematically focused mutual funds provide telling insight into most individual's inability to achieve and maintain a systematic and disciplined approach to the investment process.

In developing this study, our goal was to estimate how the average investor had performed over a five year period, compared to how that same investment vehicle (mutual fund returns, net of fees) performed over the same time frame. These actual and investor returns have been asset weighted using the fund's July 31st, 2008 share-class net assets, in relation to the size of the comparable universe. We concede that, ideally, this study would take into account the change in each individual fund's sizes over these time frames -- but for simplicity's sake, knowing the general theme and story would remain, we've chosen to use the most recent month's data.

Underperforming Your Own Investments: Not only possible, but probable

First, let's look at how the investors of actively managed mutual funds have fared over five years. As is illustrated below, investors on average have underperformed by anywhere from 1.00% to over 3.00% on an annualized basis over five years!

Additionally, the second chart shows how individual investors of Index Funds have performed over the same time periods. As some individuals have elected to disdain the concept of active management, the data below shows that even index investors consistently fail to achieve the returns of the indices that they're invested in, despite some studies that have demonstrated the underperformance of actively managed mutual funds relative to the indices.

One of the more interesting aspects of this study is of how it renders the Active vs. Passive investment approach debate irrelevant. The purpose of this study is not to promote or discredit either theory -- but instead to provide hard evidence on the actual experience of the average investor who chooses either path.

From a different perspective, let's take a look at how many individual fund investors actually perform in-line, or better than, the fund that they're invested in. This is depicted in the following chart showing different categories of index and actively managed funds on an equal weighted/average basis, and the results aren't pretty.

As shown, only slightly more than 50% of equity index and actively managed fund investors have performed at least in line with the underlying funds. The same can't be said for internationally mandated funds, as those investors have experienced worse performance than the funds themselves over 70% of the time for index funds, and over 60% of the time for actively managed funds.

Fixed income fund investors have, likewise, experienced an inferior performance over 50% of the time.

So while many people are often asking themselves: "If I make an investment in this fund, will I beat the market?" The real question they should be asking is: "If I make an investment in this fund, will I perform in-line with the fund itself?" Sadly, the answer to both iterations of the above question is a resounding, "No!"

The Hidden Cost: What you don't see is delaying your retirement

So how would this directly affect your portfolio's performance? We took a hypothetical 80/20 split between US Equity and International Mutual Funds (a composition which is generously conservative, given the data we've compiled on international allocations of the average retail investor over the past decade). We captured a loss of over $11,000 over the five year period due to investor behavior and emotion!

The bottom line is that prior to making your next sizable contribution to a mutual fund, does knowing that you have a 50/50 or less chance of achieving the actual returns of that fund over the next three or five years make you second guess that decision? Are you chasing performance into a fund or sector that may be near the end of its run? Are you only now rebalancing or cutting back on exposure from your natural resource and international funds, or have you "doubled-down" now that they've pulled back in recent months? Those are just some of the irrational and emotion driven investing mistakes that drive the discouraging data points illustrated in this piece.

As a small aside, and seeing as I've recently become a proud new father to a Weimaraner puppy (Winston), the top two items typically on my mind tend to be the markets, and Winston. It struck me the other week when I took him to his first obedience training course, when the instructor said, "Only 20% of this obedience class is actually geared towards training the puppy. The other 80% is training the owner on how to properly manage and handle the dog."

I believe, and this data supports, that far too often we see the market through this faulty logic, whereas it isn't us but the markets that need to be "corrected" to conform to our wishes and demands. Instead of educating our emotional sensibilities, realigning our expectations, and adhering or outsourcing to a systematic investment process, we expect the markets to change to suit our ways.

Now if I could just decide what I want to train my dog to fetch for me -- beer, or pizza. Would it be irrational to expect both?