In building portfolios, investors that don’t have set goals, a thoughtful plan or haven’t set some expectations, are just wondering around for the latest ‘great stock’ or ‘best performing fund’ to invest in. This is known as ‘fund collecting’ where investors are just purchasing stocks or funds as they go without thinking how they all fit with what they are trying to achieve. This investment behavior is dangerous as it leads to losses in confidence (if something bad happens) as well as actual losses in portfolio. Because most of these investors are following the successful areas of the market they are also making other mistakes in the process, such as market timing, performance chasing and reacting to market ‘noise’. Investors that don’t have a plan, tend to purchase highly rated funds (rated by Morningstar on their 1 to 5 star scale) that have very good past performance track records, but the truth is that most of these funds tend to underperform in the next few years (as the sector or opportunity cools off). As Figure 1 below shows, the highly rated funds have underperformed their benchmarks for the following 36 months after receiving a good rating from Morningstar. Again, performance chasing at its worst, creating losses for these types of investors, that then lose confidence and sell for a loss, repeating the same mistake again and again. (See Figure 1 below).
Figure 1. (From Vanguard Research)
In addition to fund and stock picking, investors without a plan tend to follow the market as a whole, so moving into stocks after they have shown great performance and exiting after they have shown poor performance. As Figure 2 below shows, the fund flows (showing how investors are putting money in stocks or bonds) shows that investors that are not following a certain plan tend to ‘buy high and sell low’ following their emotional response to fear and greed. “For example, from 1993 to the market peak in March 2000, investors’ allocation to stock funds nearly doubled, and in the two years preceding that peak, as the market climbed 41%, investors poured nearly $400 billion into stock funds. Unfortunately, the stock market then reversed rather dramatically and returned –23% over the next two years.”
Figure 2. (From Vanguard Research)
Having a plan with a set of goals and reasonable expectations, should help most investors to overcome these basic emotions that make them do the exact opposite of what they should be doing. Again and again, many new investors that start on their own fall prey to the same stories (maybe with different ‘actors’), but with very similar bad results.
We believe that time and effort should be spent on building an appropriate investment plan that has a good chance of achieving your goals, rather than on the headlines and fads of the moment. During the tough times, we can count on history to guide us through, as we know that after every ‘storm’ (no matter how long it is) there are ‘calm waters and sunshine’ that awaits the patient, persistent and rational investor.
Lead Advisor, InvestEd.