Investor Mistake #3: Chasing Performance

Don't chase performance.  It's one of the oldest, most commonly given pieces of investment advice.  Yet, most investors do it.  How do I know that, and why do they do it?

Let me answer each separately.

How do I know that investors continue to chase performance, despite every advisor, book, and CNBC Commentator out there telling them not to?  There is the study done by a group called Dalbar.  In July 2003, they calculated the return of the S&P 500 over the prior 19 years, which was 12.22% annualized.  During that same period the average equity investor earned a meager 2.57% annually.  This was lower than the 3.14% that inflation averaged.  There is only one reason for the disparity.  Performance chasing.

Equity investors were not the only ones to chase performance.  Fixed income investors averaged an unimpressive 4.24%, versus the Long Term Government Bond Index average of 11.70%.

The reasons are clear.  Investors jump into stocks or mutual funds only after they have made a siginificant increase in price, and quickly jump out at the first sign of trouble.  Rather, not at the first sign, but after unbearable losses have been suffered.  Market cycles tend to run every 2-5 years.  Most investors are not comfortable diving in until they are tired of hearing from co-workers and neighbors about how much money they are making.  Of course, that is generally right at the peak of the cycle.  After the market goes through the down side of the cycle, they get scared, frustrated, or suddenly conservative, and bail out somewhere near the bottom.

Even in the mega bull market of the 80s and 90s, there were bear market cycles every several years.  Investors became comfortable enough to jump in around 1986 or 1987 only to  get clobbered in October, 1987.  After the strong market that followed, investors became comfortable enough to invest again by around 1989 or 1990, only to suffer losses during the bear market of 1990.  Most of the 90s continued positive, but 1994 spent most of the year negative, and it was enough to scare investors once again.  In 1998, the three and a half bear market that accompanied the Russian bond crisis and the collapse of Long Term Capital Management sent a large number of investors to the exits.  By 1999, they were convinced stocks would never again go down.  And in early 2000, they thought it was a buying opportunity.  Convinced that the turnaround was near, they held until the summer of 2002, when the post 9-11 sentiment coupled with the Enron and Arthur Anderson scandals to cause one of the worst bear markets in U.S. history.  Most were too afraid to invest in 2003, but waited until 2004 or 2005, at which time, returns have been meager, and volatility very high.

The bottom line.  I have expressed in other posts that some forms of market timing may actually add value or reduce volatility to your portfolio.  I stand by that, however, don't make your decision of being in or out of the market based on recent returns.

And most importantly, read my disclaimer:  This is general advice. You should consult with your own financial advisor before making any major financial decisions, including investments or changes to your portfolio.  You, alone, are responsible for any losses or damages that may and will likely result from your financial decisions.

Comments

[Tim MMF]

I agree. It makes no sense, especially when one of the most basic and well known slogans of investing is "buy low, sell high." It irritates me that right now you hear a ton of "buy gold now" ads when the price is high instead of when gold was at record lows. Those kind of ads seem predatory to me. Anyway, great post!