Avoid this pattern of behavior by using the DR Strategy…
Greed and Fear conspire to disrupt even the most well considered investment strategy and those emotions are formidable opponents for most investors.
Quite simply, the majority of investors have a hard time resisting the emotions of greed and fear. The data is clear on the negative impact of greed and fear on investor returns (Dalbar2012). The Dalbar study calculated that, over the previous 20 years, investors who succumbed to the cycle of greed and fear (tried to time the markets) earned returns that were about 50% lower than they would have been had they resisted those temptations.
One of the reasons for this behavior is that people tend to be overconfident when evaluating noisy (highly variable) data. In short, they see patterns where there are none. Unfortunately for investors, stock market and economic data is extremely noisy and the news media adds to the problem by perpetuating the idea that successful investing requires being able to see nonexistent patterns in noisy data.
Take a look at the table below for example.
This table lists the returns for the major asset classes, best to worst, since 1998. Each asset class is represented by a different colored block. The orders of the colors look random from year to year doesn’t it? Well, that’s because the order is essentially random.
For a more thorough explanation of this table, we encourage you to watch our video by clicking here.
The Year 2014 offered a perfect example of the behavior examined in the Dalbar report. The opening line from an article published on December 27th of 2014 says it all.
“Investors in U.S.-based funds poured $36.5 billion into stock funds in the latest weekly period, marking the biggest inflows on record, as U.S. stocks surged to record highs data from Thomson Reuters Lipper service showed on Friday.”
Much of the inflow was concentrated in large US stocks. It’s no coincidence that large US stocks were one of the best performing asset classes in 2014. Once again, investors exhibited the kind of behavior illustrated in the graphic above. They bought in after the good performance had occurred.
Investors simply have a hard time resisting the urge to buy the current best performing asset class and sell the current worst performing asset class. Unfortunately for them, this is the same as buying high and selling low.
The point of this post is not to predict that large US stocks are overvalued or that they won’t offer investors good returns in 2015. Instead, the point is to call attention to a pattern of investing behavior that will lead to poor returns over time.
There is a strategy that investors can and should do use minimize the impact of greed and fear on their portfolios. We call it the DR Strategy.
First, investors should use broad Diversification to reduce risk. Broad diversification among asset classes helps mitigate the impact of negative periods and ensure that a portfolio has exposure to the best performing asset class in any given period. It of course also ensures exposure to the worst performing asset class. But that is handily dealt with the second part of the strategy described next.
Second, Rebalancing a portfolio to its target allocations on a periodic basis with force an investor buy low and sell high which is exactly the opposite of the destructive behavior described in the Dalbar study. This means buying some of the worst performing asset class and selling some of the best performing asset class on some occasions. That’s very hard to do unless an investor has a disciplined process in place but it is the key to managing risk and earning the returns available from the capital markets.
The DR Strategy will not result in a portfolio that has the best returns in every period. However, it is very likely to produce more reliable rates of return and increases in long term portfolio value than a strategy that’s easily impacted by greed and fear.
Make a New Year’s resolution to embrace the DR Strategy. Your portfolio will be glad that you did.
For more information on this and other important investment topics, please visit our website at www.independenceadvisors.com.