Saturday, November 18th, 2017

Equity mutual fund investors cost themselves $106B

Evidently many so-called investors have not realized it, but the U.S. equity market has approximately doubled since the panic lows of March 2009.  I say they are so-called investors because they evidently do not understand the difference between investing and speculating.  Investing consists of making careful, patient, long-term, strategic decisions to invest in assets whose historical characteristics match your time horizon.  Speculating is a short-term bet that a particular price trend will exist.  I believe many who call themselves investors are actually speculators – how else to account for the wild swings in flows of money into and out of equity mutual funds?

Equity mutual funds are not just an investment product, but an investment method.  A mutual fund in most cases does not contain a static group of companies, but rather a collection of shares of businesses, selected by the fund manager, who obviously believes they offer good investment value.  Over time the composition of the fund investments changes.  Investing in an equity fund involves placing a degree of trust in the knowledge, experience and skills of the fund manager.  On the recommendation of a caring financial advisor, the investor is delegating daily investment decision-making to the fund manager, or to a few or even several fund managers as a healthy, diversified portfolio is constructed.

But what does the average “investor” actually end up doing?  The evidence shows they, either alone or with the cooperation or even encouragement of their advisor, if they have one, are doing a very poor job of allocating assets for long term gains.  We regularly see the results of the annual study “Quantitative assessment of investor behaviour” by a research company named Dalbar Inc., that shows average equity fund investors greatly underperforming the average fund because of emotional decision-making.  Well, a recent article from smartmoney.com documented the vast opportunity missed by U.S. equity fund investors over the last few years.

The author referenced U.S. industry data showing that over the last five years $490 billion has been withdrawn from equity mutual funds, and there were only three brief periods where this trend was reversed, each time just before another period of market decline.  He tabulated the monthly flows of mutual funds and the monthly equity market performance.  In a given month, there was a certain amount of money invested, and people either added to this amount or made withdrawals from it, so he estimated the monthly gain or loss for the entire equity fund set.

Amazingly, he calculated that the so-called investors actually managed to miss out on $106 billion of gains through their trading activity.  The two charts below document the madness.  The one at left shows equity market performance, and since the bottom it has been very good indeed.  The one at right shows the flow of money in and mostly out of equity mutual funds. It shows the degree to which fear has driven people to sell their equtiy investments during a period (since the panic bottom of March 9, 2009) when there was a powerful recovery for dollars that had experienced the decline of 2007-2009 or there were extremely large gains for dollars that were added along the way.

I believe this demonstrates one of the most important reasons why clients desperately need my advice: my practice is not based on investment selection and market timing, but on creating and sustaining sound investor behaviour.  There is a whole generation of investors who will never recover from the investment market pain of the last five – nay, the last 14 years – since the internet bubble took off in earnest.  How can they possibly recover now that they have missed much of the large gains from the bottom of the cycle, when they have been desperately pouring the money they withdrew from equities into bonds and other income products?  A 10-year bond these days pays just over 2%.   An investor who sold out of equities at the bottom three years ago and who has missed a 100% gain would require 36 years at 2% to double his money – in other words, it would take the same time many people spend working in life just to break even.

But it gets worse.  With bonds at historical low interest rates and likely being right around the end of a 31-year cycle that has seen interest rates fall from about 20% to 2%, it is highly likely that the next decade or more will be a period of rising interest rates.  In such a period, prices for bonds fall because new bonds are issued at higher rates, making the old ones less attractive.  For example, from the early 1930’s until 1981, after accounting for inflation, bonds had about a 50-year period where they actually were worth less at the end than the beginning, and the trend was downwards almost the whole time.  Just imagine seeing your purchasing power eroded steadily for such a long time – yet that is what people did, and what they are all set up to do over the next bond cycle, however long and painful it may be.  Stay tuned.

The world economy is not and never will be out of the woods.  On any given day there are many events, trends and ideas that you can worry about and which seem devilishly designed to lead you to make emotional investment decisions.  It is my philosophy that my task is to help you manage the tendencies towards such decisions and that this advice will prove far more valuable to you than the fees I earn providing it.

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