Do You Project Recent Trends Into The Future? - BusinessBlog : McGraw-Hill
Finance & Investing

Do You Project Recent Trends Into The Future?

Guest post from Larry Swedroe, co-author of Investment Mistakes Even Smart Investors Make.

As we age, our long-term memory skills tend to remain strong, while our short-term memory skills erode. Unfortunately, individuals don’’t benefit from that tendency when it comes to investing. Larry Swedroe, author of Investment Mistakes Even Smart Investors Make, views this as a simple human failing: falling prey to “recency,” the tendency to give too much weight to recent experience, and ignore long-term historical evidence:

Perhaps the best example of the dangers of recency are provided by the following study. The Financial Research Corporation looked at fund flows following the best and the worst four quarters for each of Morningstar’s 48 investment categories. What they found is that investors follow a consistent pattern of buying high and selling low — not exactly a prescription for investment success. In the quarters following high returns, an average of $91 billion in net new cash flowed into funds — investors bought high. On the other hand, after the worst performing quarters, cash inflows dropped to just $6.5 billion — investors missed out on the opportunity to buy when the their investments were on sale.

The returns reported by mutual funds are called time-weighed returns (TWR), which assume a single investment at the beginning of a period and measure the growth or loss of market value to the end of that period. This is what we can call investment returns. Investors, however, earn dollar-weighted returns (DWR) that are impacted by the timing of additions and withdrawals. This is what we can call investor returns. And, as you will see, the DWR can differ greatly from the reported TWR.

Morningstar studied the performance of mutual funds and their investors and found that the returns earned by investors were below the returns of the funds themselves in all 17 fund categories they examined. For example, among large-cap growth funds the 10-year annualized DWR was 3.4 percent less than the TWR. For mid-cap growth and small-cap growth funds, the underperformance was 2.5 and 3.0 percent. Even value investors fared poorly, though their underperformance was not as severe. Large-cap value investors underperformed the funds they invest in by 0.4 percent per year and small-cap value investors underperformed by 2.0 percent per year.

Even index fund investors are subject to recency. We can see the evidence on this from a Morningstar study that covered the 10-year period ending in 2005. The TWR of no-load index funds was 8.9 percent, 1.8 percent greater than the 7.1 percent DWR earned by investors in these funds.

Falling prey to recency means trying to buy yesterday’’s returns. You have to keep in mind that you can only buy tomorrow’’s returns. This problem can be avoided by ignoring the media, the financial press and “expert” advice from Wall Street urging you to act on the mistaken assumption that somehow this time it’’s different. Before jumping on any bandwagon, check the long-term historical evidence and the logic of the conclusions (and watch out for overconfidence). Those who do jump on the bandwagon are likely to be found abandoning it in the near future.

Larry E. Swedroe is the bestselling author of the The Only Guide series and other successful investment guides. He writes the blog “Wise Investing” for CBS and speaks frequently at financial conferences. He is also a principal and Director of Research for The Buckingham Family of Financial Services, which includes Buckingham Asset Management and BAM Advisor Services.

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