Wednesday, February 19, 2014

Behavioral Investors and the Dumb Money Effect

Individual stock market investors often underperform the market averages because of terrible timing: in particular, they are often buy after the market has already risen, and sell when the market has already falling, and this pattern means that they end up buying high and selling low. Michael J. Mauboussin investigates this pattern, and what investors might do about it, in "A behavioural take on investment returns," one of the essays appearing at the start of the Credit Suisse Global Investment Returns Yearbook 2014. He explains (citations omitted):

Perhaps the most dismal numbers in investing relate to the difference between three investment returns: those of the market, those of active investment managers, and those of investors. For example, the annual total shareholder returns were 9.3% for the S&P 500 Index over the past 20 years ended 31 December 2013. The annual return for the average actively managed mutual fund was 1.0–1.5 percentage points less, reflecting expense ratios and transaction costs. This makes sense because the returns for passive and active funds are the same before costs, on average, but are lower for active funds after costs. ... But the average return that investors earned was another 1–2 percentage points less than that of the average actively managed fund. This means that the investor return was roughly 60%–80% that of the market. At first glance, it does not make sense that investors who own actively managed funds could earn returns lower than the funds themselves. The root of the problem is bad timing. ... [I]nvestors tend to extrapolate recent results. This pattern of investor behavior is so consistent that academics have a name for it: the “dumb money effect.” When markets are down investors are fearful and withdraw their cash. When markets are up they are greedy and add more cash.
Here's a figure illustrating this pattern. The MSCI World Index, with annual changes shown by the red line, covers large and mid-sized stocks in 23 developed economies, representing about 85% of the total equity market in those countries. The blue bars show inflows and outflows of investor capital. Notice, for example, that investors were still piling into equity markets for a year after stock prices started falling in the late 1990s. More recently, investors were so hesitant to return to stock markets after 2008 that they pretty much missed the bounceback in global stock prices in 2009, as well as in 2012.

What's the right strategy for avoiding this dumb money effect? Mauboussin explains:

"More than 40 years ago, Daniel Kahneman and Amos Tversky suggested an approach to making predictions that can help counterbalance this tendency. In cases where the correlation coefficient is close to zero, as it is for year-to-year equity market returns, a prediction that relies predominantly on the base rate is likely to outperform predictions derived from other approaches. ... The lesson should be clear. Since year-to-year results for the stock market are very difficult to predict, investors should not be lured by last year’s good results any more than they should be repelled by poor outcomes. It is better to focus on long-term averages and avoid being too swayed by recent outcomes. Avoiding the dumb money effect boils down to maintaining consistent exposure."

There are two other essays of interest at the start of this volume, both by Elroy Dimson, Paul Marsh, and Mike Staunton. In the first, "Emerging markets revisited," they write: "We construct an index of emerging market performance from 1900 to the present day and document the historical equity premium from the perspective of a global investor. We show how volatility is dampened as countries develop, study trends in international correlations and document style returns in emerging markets. Finally we explore trading strategies for long-term investors in the emerging world." In the second essay, "The Growth Puzzle," Dimson, Marsh, and Staunton explore the question of why stock prices over time have not measured up to economic growth in the ways one might expect. The report also offers a lively brief country-by-country overview of investment returns often back to 1900 in a wide array of countries and regions around the world.