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?
Only problem is, where's that signal?
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: |
(I was right!)
(I've got great market karma; few others
(I wish I hadn't bought that stock ...
aversion (I won't sell and realize
a loss because I can't admit I'm wrong)
(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.
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.
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.
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.