There is a well-documented phenomenon in stock market investing, relating to the differences in any given period between three sets of investment returns. These are the return achieved by the market as a whole, the return obtained by active investment managers, and the returns of investors.
Take for example the annual total shareholder returns for the S&P 500 Index over the 20 years ended 31 December 2013. The figure was 9.3%, between 1.0 to 1.5 percentage points higher than that achieved by the average actively-managed mutual (or unit trust) fund. (As we know, the majority of active fund managers fail to match or beat the market, largely because of expense ratios and transaction costs).
Given this information, you would expect the average return earned by investors in an actively managed fund over this twenty year period, to be somewhere between 7.8% to 8.3%. But, curiously, this is not the case. It turns out that the return obtained by investors was another 1.0 to 2.0 percentage points lower than that of the average actively managed fund. This translates into a return which is some 20% to 40% below that of the market.
How is this possible? How could investors in an actively managed fund obtain returns lower than those earned by the fund itself? The answer lies in a pattern of investor behaviour that is so consistent that academics have given it a name: the ’dumb money effect’. It results from the fact that, when markets are sinking, investors generally become fearful and withdraw their cash. However, they become a lot more courageous when markets are soaring, and tend then to enthusiastically increase their holdings.
A simple example will illustrate the effect that the dumb money effect can have on investor returns. In the first instance, imagine an investor who buys 100 shares in a managed fund at the beginning of Year 1, at a cost of R10 000. This investor has a buy-and-hold strategy, so that when the value of his investment grows by 20% to R12 000 at the end of Year 1, he takes no action. A year later the fund has fallen back to the level it was at two years earlier, and so with an investment valued again at R10 000, the buy-and-hold investor’s return over the two-year period is zero.
Not good news, until you consider the example of the typical investor. He too pays R10 000 at the beginning of Year 1 for 100 shares, and is thrilled when his investment grows to R12 000 by the end of the year. He is so thrilled, in fact, that he doubles his investment, paying an additional R12 000 into the fund for a further 100 shares. His total cash outlay at the end of Year 1 is therefore R22 000. But, as we know, the fund is destined to fall back to its earlier level, so that by the end of Year 2 the bullish investor’s shares are worth R20 000, and he has lost R2 000 for an overall negative return of 9.1%.
Why do most of us behave in this irrational manner? Well, as it turns out, we shouldn’t be too hard on ourselves because it seems that we’re hard-wired to do so. There is a part of our brain, located in the left hemisphere, that neuroscientists have named ’the interpreter.’ What the interpreter is designed to do is to establish a cause for every effect that it detects. In this way, we have become pretty good at understanding the world around us. The interpreter has also provided us with a multitude of impressive technological advances.
All good and well, but why does the interpreter let us down when it comes to investing? The answer lies in the left brain as well, because this is also where our personality and ego lives. And so, in the case of our second investor, when his investment grew by 20% at the end of Year 1 his interpreter immediately sought out a cause for this effect. Unfortunately, the rational interpreter wasn’t allowed to carry out the task unaided; as you may have guessed, the investor’s ego got involved as well.
The result? In answer to the interpreter’s question as to the cause of the investment gain, the ego jumps up and down shouting "It was me, it was me!" And so the wise interpreter gets hijacked by the ego, which then decides to cash in on its original brilliant investment choice by pouring more money into the same investment.
Herein lies the problem. Whenever we obtain favourable results by way of luck, we don’t acknowledge this but rather ascribe our success to our own brilliance. As investors we shouldn’t feel too bad, because the history of science, for example, is littered with examples of brilliant people reaching poor conclusions because their egos got in the way.
Academics have found the dumb money effect to be widespread. For example, a study by Dichev (2007) examined the difference between market returns and investor returns in 19 countries (including South Africa) over the twenty-year period ended 2004. The results showed that, on average, investors earned 1.5 percentage points less per year than a buy-and-hold strategy, as a direct result of the dumb money effect. If it is any consolation, South Africans fared slightly better than investors in the majority of countries, earning on average 1.0 percentage point less than a buy-and-hold strategy.
This suggests that most investors would be better off following a buy-and-hold approach than relying on their own judgement. However, there is an alternative strategy that could provide even better returns without requiring investors to take on more risk. In various articles over the years we have described this approach, first suggested by the great Benjamin Graham, mentor to Warren Buffet.
Graham suggested that investors should split their portfolio between shares and bonds (or equivalent unit trust funds). The younger the investor, the greater the percentage that should be invested in the stock market. Conventional wisdom suggests a percentage holding of 100 less the investor’s age, so that a twenty-five-year-old would hold 75% shares and 25% bonds, by value. A portfolio worth R10 000 would therefore consist of R7 500 in shares and R2 500 in bonds.
The investor should then ’re-balance’ the portfolio every six to twelve months, on a pre-determined date. So, if after a year the shares in the portfolio had gained in value by 20% and the bonds had maintained their original value, the total portfolio would be worth R11 500. Re-balancing would mean that 75%, or R8 625 should be invested in shares and R2 875 in bonds.
As the original share investment of R7 500 will have grown to R9 000, R375 worth of shares would be sold, and the proceeds would be used to buy bonds. This illustrates how, in a rising stock market, the investor can regularly take some of the profits earned and move them into less-volatile bonds. This is in direct contrast to a buy-and-hold strategy where, as has been seen, no benefit is obtained from a short-term stock market rise.
This also implies that, in a falling share market, the investor will be selling bonds and buying shares. The investor’s ideal is therefore achieved; shares are sold when they rise in price, and bought when the price falls. This is a logical counter to the ’buy high, sell low’ approach evident in the dumb money effect, and followed by the majority of investors.
The lessons that emerge from the dumb money effect are clear. As year-to year results from the stock market are difficult to predict, investors shouldn’t be fooled by last year’s good results, or put off by negative returns in a particular year. It is far better to focus on long-term positive returns, because this is what consistent exposure to the market will ensure. This, we would suggest, is the smart money approach to stock market investing!
Michael J. Mauboussin (2013). A behavioural take on investor returns. Credit Suisse Global Investment Returns Yearbook, 2014.
AJ is an academic and a freelance financial journalist who has written for Sharenet for some 15 years. He spent 25 years as an accountant and financial manager in various South African companies before moving into academia. He has a broad range of interests, including all aspects of business and stock market investing. Apart from a bachelor’s degree in Accounting, AJ holds a Master’s degree in Financial Management. He is also a Fellow of the Chartered Institute of Management Accountants.