Each year I visit my Alma Mater, the Ivey School of Business at the University of Western Ontario, to teach a seminar to MBA students. It’s one of the highlights of my year because I’m given a soapbox by my good friend Professor Steve Foerster on which I teach/preach to students on the perils of letting your emotions drive your investment decisions.
It’s great fun. The students are always engaged and they pepper me with questions. Surprising to me is that most don’t have an “I’d never do that” attitude and dismiss my warnings. Rather, they ask thoughtful questions showing me that they are really thinking about my lessons. I might be delusional, but I always leave the class thinking that at least a few of them will make better decisions going forward with their money.
On my way home I was listening to the news. The stock market had just risen for the fifth straight business day. In fact, at that point, near the end of March, the stock market (S&P 500 Index) had more than doubled since its most recent low in March 2009 during the financial crisis. The obvious question for me was how had most investors navigated the last three years? After all, I had just warned MBA students of the perils of letting emotions cause one to “buy high and sell low.”
The data for the past three years shows that most investors are still driven by their emotions. Most investors were buying high and selling low. Since the beginning of 2008, the data on mutual funds shows that for every $1 invested in equity funds, $4 has gone into bond funds. Despite the best Boxing Day sale on equities in 40 years, people lined up to buy bonds.
John Bogle, the Chairman of Vanguard Funds and a long-time advocate of investor education, has estimated the cost of this kind of behaviour to investment returns. Using the difference between U.S.mutual fund returns and the return for investors in these same mutual funds, he estimates that people systematically eliminate approximately one-third of their potential return. Said another way, if the return for the average mutual fund was 10% per year, then the average person invested in those same mutual funds had a return of only 6.3%.(1)
How can this happen? The mutual fund return is the return for $1 that remains invested over the calculated time period. However, the return for investors is the actual return on their investment in the mutual fund. So, if investors bought and sold their investment at different times during the calculated period, then they likely have a different return than the mutual fund. In fact, because the average investor had typically bought high and sold low, the investor return was significantly lower than the mutual fund return.
If they had invested in the mutual fund and did nothing, they would have made 50% more. But they did not. They let their emotions drive their actions. When the financial crisis hit, they fled because they were scared. And now that equity markets are up significantly, they are wading back into the pool at much higher prices. This behaviour is bad for their wealth. They shouldn’t have taken their money out in the first place.
This is an important topic, not just for MBA students, but for all investors. Over the next while, I will explore in more detail some of the contributing factors to this behaviour, including herding, overconfidence, risk aversion and regret avoidance. Stay tuned.