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Columns: Boomer Bucks
Barbara Mlotek Whelehan Expert: Barbara Mlotek Whelehan
Boomer Bucks
Buy-and-hold investors do better in the long run
Boomer Bucks

Investors their own worst enemy
 

Investors are likely reeling from the thrill rides provided by the stock market in recent weeks. Have you been tempted to jump off and wait for the "all clear" signal to climb back on?

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Only problem is, where's that signal?

Fear and greed rule our behavior, and lately fear has been the dominant emotion. While fear causes us to sell and greed impels us to buy, the behavioral finance field offers more nuanced states of mind.

In reality, emotions shouldn't play a role in investment decisions at all. They cause us to lose in two ways: We incur trading costs when we buy and sell (and this activity could have tax ramifications, too). And then because we can't forecast precisely when the market will rebound, we miss out on potential gains.

Some emotions that thwart us:
Overconfidence (I was right!)
Optimism (I've got great market karma; few others do)
Regret (I wish I hadn't bought that stock ... )
Loss aversion (I won't sell and realize a loss because I can't admit I'm wrong)
Herding (I'll follow the crowd because millions of investors can't be wrong)

We should coolly and rationally make appropriate asset allocation decisions and continue to throw money at regular intervals into the funds we select, regardless of market moves.

Self-sabotaging syndrome
Nevertheless, market volatility causes investors to worry and move in and out of stock funds. Since 1984, the research firm Dalbar has tracked investors' mutual fund purchases and sales. In its 2007 Quantitative Analysis of Investor Behavior, Dalbar sees an improvement in investor fortitude, but observes: "Mutual fund investors who hold their investments are more successful than those that time the market."

It turns out that mutual fund managers can also be afflicted by neurotic investment behavior. "Even professional investors are prone to make poor trades when ingrained habits lead them astray," according to a recent MarketWatch article on behavioral finance that looks at the foibles of fund managers.

Don't go with the flow
In all fairness to fund managers, fickle investors flowing in and out of funds are partly to blame for many of the managers' poor trades. Gregory Kadlec, a featured speaker at the recent Morningstar investment conference, estimates that between 30 percent and 50 percent of all fund trades are operational in nature, "and the biggest culprit of these operational trades is shareholder flow."

For funds, trading costs run much higher when fund managers are forced to sell stocks immediately to meet redemptions. "If you're making a trade for purely operational reasons, it stands to reason that all of the costs are going to flow through to the bottom line," says Kadlec, a professor of finance in the Pamplin College of Business at Virginia Tech. Translation: Fund performance suffers.

Industry watchdogs have been muttering about fund trading costs for years. They're particularly pernicious because investors have no way of knowing how much their fund managers trade and how much the trades cost. Turnover is considered a barometer, but that can be misleading. "Turnover is a poor and unreliable proxy for a fund's actual trading costs," says Kadlec, who adds that existing studies on the relationship between performance and turnover show a positive or negative correlation, or no correlation at all.

The academic findings
Along with two other academics, Kadlec spent a year studying the impact of trading costs on mutual fund performance. The authors' main finding: Annual trading costs amount to 144 basis points on average, or 1.44 percentage points, for domestic equity funds. That's more than the average expense ratio of 1.21 percent, so trading costs can make a significant dent in performance.

Next: " ... Not all trading is detrimental to shareholder wealth ... "
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