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Time Of Year Investors Make Biggest Mistake

  • Written by Syndicated Publisher No Comments Comments
    December 29, 2013

    We are coming to the time of year when studies show investors make one of their most costly mistakes – chasing performance.

    At the end of each year the most common activity of investors is to flock to screening tools on the Internet, and review ‘Top 25 Mutual Funds’ lists in magazines, and “Best Stocks of the Last 12 Months”, “Best Strategy of the Year”, and so on, to find out which funds, stocks, or strategies were the top performers the previous year, or for the previous three years, and jump out of their under-performing holdings and strategies into those.

    “How quickly investors flock to better-performing mutual funds, even though financial researchers have shown that the “hot” funds in one time period very often turn out to be the poorest performers in the next period.”   David Dreman, Dreman Value Management.

    How great an approach is it, even on its surface, to bail out of a mutual fund or a strategy after it disappoints and may be at a low, and buy into one that was up significantly the previous year, considering that the most obvious rule for successful investing is to buy low and sell high?

    And indeed, in regard to stocks and mutual funds, many studies have shown that a list of the previous year’s losers is more likely to be fertile ground for finding the following year’s winners, as they are more likely to be oversold and due for a reversal to the upside.

    In a 2012 study by international wealth management firm Robert W. Baird & Co., the firm screened equity mutual fund performance from 2001 through 2010, and found 370 funds that had beaten their benchmark over the ten years by at least 1% on an annualized basis, and with less up and down volatility than their competitors.

    Yet the study showed that 85% of even those best fund managers had at least one 3-year period in the ten years, not one-year but three, when they underperformed their benchmark.

    No mutual fund, no money-manager, even the best, can be right every year or in every period.

    But that is what retail investors want and expect to be able to find. And in their attempt to find a never failing fund or strategy, they repeatedly do themselves great harm.

    The Baird study concluded that, “High-performing managers experience inevitable weak periods. They then make up for the lost ground by making excess returns in subsequent periods to get back at the top. But investors leave those big make-up gains on the table because of short-sighted decisions to leave after the poor performance period, chasing into someone else who is in their top-performing period. Buying high, selling low.”

    The highly respected Morningstar rating service finds similar investor behavior over the entire universe of more than 20,000 mutual funds that it tracks.

    It reports that money-flows show that each year investors switch money out of funds poorly ranked on recent three-year performance, into those that are highly ranked for recent three-year performance.

    Meanwhile, the top-ranked funds are usually those that happened to be in the hottest sectors in the previous measuring period; technology, the financial sector, small-cap sector, emerging markets, or whatever, which are likely to be overbought and due for correction to the mean.

    John Rekenthaler, Morningstar’s vice-president of research, says that almost always “Investors piling into the hottest funds of the previous period will be sorry, since the lower ranked funds tend to be the winners over the next three-year period”.

    A study Morningstar conducted in 2003 found that the  best performing mutual funds over every four-year period going all the way back to 1976, were unable to repeat the performance over the next four-year period. In fact, even the best 30 funds in each period, out of the thousands that are available, significantly under-performed the market in the next four-year cycle, and most often did not come close to even average performance.

    The same pattern holds true for investment strategies.

    Every successful strategy, including the various methods of market-timing, and especially ‘buy and hold’, runs into periods when it works exceptionally well, and periods when it underperforms. Abandoning a proven strategy after a period of underperformance to jump into one that just enjoyed an unusually positive period is usually a mistake.

    Consider famous long-time successful investors and managers, and the list is long, the likes of Warren Buffett, George Soros, Bill Gross, Peter Lynch, John Paulson, et al.

    All have significantly different investment strategies.

    When one of them has an underperforming year, or two or three in a row, as they all periodically do, do they scrap their own long-time strategy and switch to that of one of their rivals who had an outstanding year? Of course not. Yet Buffett for example, has had one to three-year periods when he was down as much as 45%. But they are disciplined, experienced, understand markets, stick with their strategy, recover and climb back to the top again.

    Yet abandoning a strategy after even minor underperformance is almost the norm among public investors. Studies show that average investor patience for underperformance runs about 9 months. That’s especially true if a different strategy just had outstanding performance, and is getting publicity in the media.

    Mark Hulbert, editor of the Hulbert Financial Digest, has tracked and evaluated investment newsletters that follow various strategies since 1980.

    A study Hulbert published in 2011 confirmed that, like mutual funds and professional investors, even the best performing newsletters do not outperform the market every year. Hulbert reported that over the decade from 2000 to 2010, “Among the nearly 200 equity-oriented portfolios that HFD monitored, even those that beat the market significantly over the ten-year period had to suffer through at least one losing year during the ten years.”

    In fact, he reported that during the 1990s, the top long-term performers underperformed the market an average of 2.2 calendar years out of every ten, before moving back up into the top-ten performance rankings. That’s approximately the same as Warren Buffett’s experience.

    Statistics show that investors have dismal performance over the long-term. And chasing performance is just another example of how non-professional investors find ways to buy high and sell low. And they are approaching year end, their favorite time to take that approach.

    GOLD.

    Gold bugs are trying to make something happen, not surprising considering that gold is at last ditch support.

    122813e

    However, the intermediate-term overhead resistance at the 30-week m.a. (not shown) is only 7% above yesterday’s close.

    And on the short-term chart above, the first short-term overhead resistance at the 30-day m.a. is at $1,238 an ounce, just 2% above yesterday’s close, while the trendline resistance is at roughly $1,260, is less than 4% above yesterday’s close.

    At some point, gold will find a bottom, and this may even be it.

    But betting on that before it has cleared any overhead resistance at all is a high risk move.

    To read my weekend newspaper column click here:  Investor Expectations Also Need Tapering As We Enter 2014

    Images: Flickr (licence attribution)

    About The Author – Sy Harding, Street Smart Report

    Sy Harding publishes the financial website Street Smart Report Online and a free daily Internet blog at Sy’s Free Blog. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!

    It includes our research and analysis on the economy and markets, and provides charts and buy and sell signals on the major market indexes, sectors, bonds, gold, individual stocks and etf’s, including short-sales and ‘inverse’ etf’s.

    It provides two model portfolios as guides. One is based on ourSeasonal Timing Strategy, one on our Market-Timing Strategy.

    In depth updates are provided every Wednesday, with interim ‘hotline’ updates every time we make a trade. An 8-page traditional newsletter Street Smart Report is provided on the website every 3 weeks, in pdf format for viewing or printing out.

    There is the Street Smart School of online technical analysis ‘seminars’,commentaries to keep you ‘street smart’ about Wall Street, and much more. 

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