Avoiding buy-high, sell-low syndrome

In its new study, Dalbar shows how investors can manage their psyche to capture 'alpha' or excess returns.

Mon, Apr 18, 2011
The Business Times

By Genevieve Cua

BY NOW, you would be familiar with the defeating pattern of investors buying high and selling low. It crops up almost invariably at moments of stress in markets.

In its latest Quantitative Analysis of Investor Behavior, US-based Dalbar comes up with suggestions on how to overcome the behaviours that tend to rob investors of 'alpha' or excess returns.

'It continued to be a struggle to help investors protect and grow portfolios by taking advantage of the behaviour of investments and using the available time horizons . . .

'When investor behaviour is anticipated and investment plans are developed and maintained, investors will capitalise on the alpha created by the strategies and tactics of financial advisers and portfolio managers. Investors must be guided to rely more on the probabilities of history than the possibilities of emotion - this seems possible but is complex.'

Dalbar has been studying US investor behaviour through mutual fund flows, using data from the Investment Company Institute, S&P and Barclays Capital Index Products. The latest study spans 1991 to end-2010. It uses mutual fund sales, redemptions and exchanges to surmise investor behaviour.

The study shows that across almost all periods, investors did markedly worse than the respective benchmark indices. One exception is the one-year period in 2010 where the average equity investor saw a return of 13.6 per cent against the S&P 500's 15 per cent return.

Against inflation, there are some long periods where the equity investor did beat inflation. Over 20 years, for instance, the investor earned an annualised 3.83 per cent, against inflation of 2.57 per cent. Dalbar says this is due more to unusually low inflation rates, rather than improved investor returns.

The fixed-income investor appeared to fare relatively much worse, ironically in a long period hailed by fund managers as the best for the asset class. Over a 20-year period, the bond investor saw annualised returns of just 1.01 per cent, against the Barclays Aggregate Bond Index's return of 6.89 per cent and inflation of 2.57 per cent. Ten-year returns were relatively worse; the investor earned 0.77 per cent against the index's 5.84 per cent and inflation of 2.48 per cent.


Average holding periods based on 20 years of data have improved somewhat but remain relatively short at about 3.27 years for equity investors, 3.17 years for fixed-income investors, and 4.29 years for asset allocation investors.

This relatively short horizon is part of the reason for the gross underperformance. 'One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long enough periods to derive the benefits of a long-term investment strategy.'

Dalbar says its charts show that 'recommendations by many mutual fund companies to remain invested have had little effect on what investors actually do'. 'The result is that the alpha created by portfolio management is lost to the average investor, who generally abandons investments at inopportune times, often in response to bad news.'

Still, a year-by-year analysis shows that the underperformance gap has actually narrowed. In 2000, the investor underperformed the S&P 500 by 10.97 per cent. By 2010, this had narrowed to 5.31 per cent. Dalbar says this could be due to the fact that investors who had been in the market in the 1990s would have experienced multiple market corrections and recoveries and might have learnt from the experiences.

Some investors and advisers, however, have been able to avoid 'alpha robbing behaviour'. This was achieved through better understanding and management of the psychological factors, and a better understanding of the investments as well.

'While a buy-and-hold strategy prevents a loss of alpha . . . effective management of psychological factors, and an understanding of the 'behaviour' of investments being used, combine to produce positive alpha.'

Alpha is the excess return of a fund over its benchmark index. It is the value that a manager is able to add to a fund's return. Dalbar defines 'investor's alpha' as the value a retail investor adds or subtracts from the value delivered by the fund manager.

It says the key to curbing undesirable behaviour - such as the urge to sell when markets tank - is to simply pause and assess the facts.

In this pause, investors should assess whether they are falling prey to any of nine psychological factors. These include loss aversion, where one expects to find high returns with low risk; and narrow framing, where investors make decisions without considering all implications.

Other flaws are mental accounting, where the investor takes undue risk in one area and avoids rational risk in others; and anchoring, where investors relate their current situation to familiar experiences, even if they are inappropriate. One example is to anchor a stock price to a previous high, even if that high was excessive. This could lead investors to hang on to loss-making investments.

The second part of the solution is to understand and choose appropriate asset classes and their allocations in a portfolio.

There are some broad categories of investments depending on who is expected to seek out alpha. One are investments that alone seek alpha - that is, portfolio managers are able to enter and exit markets to outperform their benchmarks. A second category is that of 'zero alpha' - or investments that have 'styles' that remain consistent regardless of market conditions. Here, the expectation is that investors will make changes to their allocations to achieve alpha.

This article was first published in The Business Times.