The golden rule of investing is “Buy low, sell high.” But individual investors often do the opposite, buying high and selling low.
Welcome to the concept of “dumb money.” In contrast to value managers and private-equity investors, who typically take a long-term view of the markets, individual investors often chase short-term profits. As a result, they often end up losing money.
To understand the dumb money idea, you first need to understand how investment behavior is tracked. A monthly or quarterly metric called fund flow shows the amount of cash flowing in and out of various financial assets. As markets rise, the flow into equity mutual funds picks up; as markets fall, the fund flow starts to decline.
People are cyclical about how much money they invest in, and withdraw from, mutual funds. Unfortunately, they’re not cyclical in a good way.
Fund flow consistently shows that people tend to buy a fund when it’s at the top of the market. They tend to get out when it’s near the bottom. They pay top dollar to get in, and sell at a loss.
This behavior occurs because of the psychology of investing. Remember the last time you looked at one of your portfolio statements? Perhaps your stocks in some energy companies took a 25 percent hit last quarter while your technology stocks increased 25 percent in value. You contacted your broker and told him or her to sell the energy stocks and buy more of the technology stocks.
In other words, people put their money where they wish they would have put their money.
Here’s a great example. From September 1999 to August 2009, the CGM Focus Fund earned an 18½ percent return on its assets and ranked in the top of most mutual fund lists. But when fund flow is taken into consideration, the fund’s investors lost over 15 percent.
That’s because when the fund manager had a good year, everyone put more money in; when he had a little downside, people took money out. Because investors got in and out at the peaks and valleys, they didn’t benefit from the returns the fund manager generated over the long haul.
Over time, market performance is fluid. A 2005 study by two economists from the University of Chicago Graduate School of Business and the Yale School of Management found that for every period longer than three months (and out to five years), the stocks receiving the highest flows of new mutual-fund money performed significantly worse than the stocks that received the lowest flows of new money. Over a three-year period, the difference was 8 percentage points a year.
The changing dynamics of the markets are illustrated by a “return quilt” that students in one of Butler’s finance classes put together. It’s not a bed covering but a diagram with different-colored squares representing market sectors such as basic materials, communications and health care. The first column ranks the best performers from top to bottom for 1990, then 1991, then 1992, and so on.
If a market sector performed the same over time, the diagram would have a consistent color pattern per row. Instead, because of the fluid nature of the markets, the colors are all jumbled up, just as in a patchwork quilt. It’s a visual reminder that today’s winning stock, sector, or fund may be tomorrow’s loser.
What’s the best strategy to avoid dumb money? Have a diversified portfolio and stay true to that diversification and allocations over time. When coming up with your allocations, take into consideration such factors as how much time you have to retirement, how much risk you can tolerate and how liquid you want your assets.
If you’re the kind of person who gets nervous when looking at your financial statements, hire someone you trust to oversee your investments. Then take a peek every five years. That will give you enough time to anticipate big life changes such as retirement and change your investments accordingly.
Whatever you do, avoid knee-jerk reactions to market activity. That would be, well, dumb.
Chuck Williams is dean of the College of Business at Butler University. Steven Dolvin, associate finance professor at the COB, contributed to this article. For more information on the College and its “real life, real business” approach to business education, visit www.ButlerRealBusiness.com or e-mail Chuck at firstname.lastname@example.org.
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