Individual Investors Tend to Buy High and Sell Low ... While a Common Practice, It's a Horrible Way to Behave

All too often we mere mortals when acting as individual savers and investors tend to confuse that which is simple with being easy.

For example, stock prices rise over time. Thus, the case for investing in stocks over the long haul is a simple and compelling one. On the other hand, long term investing isn't always as easy as it should be. That's because we frequently let our emotions rule, and we make the otherwise simple and easy become hard and costly. As a result, we pay a horribly high price for letting our emotions take over in times of market stress and volatility.

To repeat the obvious, when buying and selling stocks, too many of us are prone to buy high and sell low. We allow our emotions to take over and overrule our otherwise rational selves. That invariably proves to be a needless and costly mistake.

This emotional versus rational behavior occurs when we mistakenly behave as if some special crystal ball exists which can accurately predict the future actions of both (1) uncertain future economic events as well as (2) how other stock market investors will react to those uncertain future events. While we tell ourselves (or let others convince us) that we (or they) have the inside story about the short term direction of share prices, we usually don't.

None of us ever knows the future with certainty. That's what makes life so interesting. Nevertheless, individuals predicting the unpredictable is why overall stock market returns outpace by a wide margin the returns achieved by the vast majority of individual investors.

How a Mutual Fund Can Win but its Investors Still Lose says this about individual investors and our tendency to shoot first and ask questions later:

"Imagine the following theoretical investment opportunity: Investors can invest in a fund that will beat the market by 5% a year over the next 10 years. Of course, there is the catch: The path to outperformance will involve a five-year stretch of poor relative performance.  “No problem,” you might think—buy and hold and ignore the short-term noise.

Easier said than done.

Consider Ken Heebner, who ran the CGM Focus Fund, a diversified mutual fund that gained 18% annually, and was Morningstar Inc.’s highest performer of the decade ending in 2009. The CGM Focus fund, in many respects, resembled the theoretical opportunity outlined above. But the story didn’t end there: The average investor in the fund lost 11% annually over the period.

What happened? The massive divergence in the fund’s performance and what the typical fund investor actually earned can be explained by the “behavioral return gap.”

The behavioral return gap works as follows: During periods of strong fund performance, investors pile in, but when fund performance is at its worst, short-sighted investors redeem in droves. Thus, despite a fund’s sound long-term process, the “dollar-weighted” returns, or returns actually achieved by investors in the fund, lag substantially.

In other words, fund managers can deliver a great long-term strategy, but investors can still lose.

Such attempts to trend chase and time exposure to active funds are not limited to the Ken Heebner example. Jason Hsu, a finance professor at UCLA, has described the behavioral return gap that occurs as fund style returns go in and out of favor. Take the case of value funds, or funds that focus on buying cheap undervalued stocks. When funds investing in value strategies underperform, those funds experience redemptions. Value fund managers must sell what they own—value stocks—to meet these redemptions. Thus, in the short run, valuations for value stocks are pushed even lower, in a negative feedback loop, driven by outflows associated with investors who seek to avoid further underperformance. At some point, valuations for value stocks hit rock bottom, returns mean revert, and the opportunity for outperformance reveals itself.

In a 2015 study, Prof. Hsu, Brett Myers, and Ryan Whitby examined the dollar-weighted and buy-and-hold returns for value funds. The authors investigated the period January 1991 through June 2003 and found striking evidence for the behavioral return gap. Over the period, value funds had annual buy-and-hold returns of 9.36%, besting the S&P 500, which earned 8.97%. However, the dollar-weighted returns for the value funds were only 8.05%.

The dollar-weight returns highlight that investors in value funds had poor timing that not only prevented them from capturing the premium offered by value investing, but also prevented them from beating the buy-and-hold passive index. It is perhaps ironic that investors eliminate the long-run benefits offered by buy-and-hold value strategies through their attempts to time in and out of them.

A famous Pogo comic strip declared that, “We have met the enemy and he is us.” This nicely depicts the conundrum facing many investors today. By basing our investment and allocation decisions on recent short-term relative performance, we destroy our ability to reap the benefits of strategies that require a long time horizon to be effective. In the end, active investing is simple, but not easy."

Summing Up

Don't let emotions rule your investing approach over the long haul. Learn to wait for the good 'stuff' at the end of the long road. Beware the 'Behavioral Return Gap.'

The simple and basic idea is to buy low and sell high. Doing that is simple, and even easy, if we let time work for us by not overreacting to short term market movements.

Confusing short term market volatility with long term risk and reward is a common practice but a terrible way for individuals to invest.

Here's the deal --- buy low, buy consistently, stay the course, and then after many years or even decades, the time will come to sell high.

It's really that simple, although admittedly not all that easy.

That's my take.

Thanks. Bob.