Overestimate, underperform

Why do people always assume that things will go on as they always have done? Apparently we can never say for sure that the sun will rise the next morning – we just think it will because it always has.

Investors seem to be applying this same reasoning to whether to buy or sell their funds – but I think the laws of fund management are far less certain. A new US paper – “Past Performance is Indicative of Future Beliefs”, by Phillip Maymin and Gregg Fisher of advisory firm Gerstein Fisher – has found that investors regularly underperform the market because they buy funds that have done well and sell ones that performed badly.

Or in other words: “Investors chase returns and in doing so create the conditions of their own demise.”

In one way, this is surprising. One of the main reasons investors often underperform is that they find it hard to sell funds that are losing money. I have no idea whether commodities will continue the spectacular falls of this week but I can guarantee someone will wish they had sold out sooner than they did.

Partly this is just pig-headedness: no one likes to admit they are on a losing streak. Vanguard, a low-cost fund manager, has done some research suggesting that inaction is the most likely path people take when they’re not sure what to do – even if failing to sell is the most stupid course of action.

Tom Stevenson, investment director at Fidelity, notes that this kind of mentality was common after the dotcom bubble burst in 2000. People held onto their tech stocks for years after the crash, hoping they would miraculously recover – and ended up losing 80 per cent of their money.

At least the US research suggests that people are managing to sell poor performers. But this may also create problems, as they may sell at precisely the point that the market turns around.

So we seem to be at a stalemate. Failing to sell a poor performing investment may mean you keep on losing. Selling it means you might miss out on the upside. How
are investors supposed to decide what to do?

An important distinction should be made here between whether you’re selling shares or funds. When looking at a share, it’s possible to make a decision based on how cheap that share is, relative to its historical price. So even if it has fallen, it might still be worth holding onto. But poorly performing funds are different. This involves making a decision about how good your fund manager is – a less logical matter than stock market valuation.

And many would argue that how your fund manager performs is just down to plain luck. Studies abound – the most recent in March from S&P – showing that the majority of active fund managers underperform their benchmarks.

But perhaps the real problem is the benchmark. Fund managers are so scared of underperforming their benchmark that they often mirror it. That way, if the fund loses value, they can abdicate (some) responsibility. Being benchmark aware is all part of the industry’s drive to be more transparent to consumers, and the Financial Services Authority’s argument that investors need some sort of meaningful comparison is sound. But by encouraging the professionals to buy shares just because everyone else is, without any rational analysis, benchmarks may be causing more harm
than good.


alice.ross@ft.com

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