How to beat the dumbo in your head

The economics profession hardly has much to shout about these days. The financial crisis exposed its shortcomings and gave us cast-iron proof that human beings are bad at making economic predictions.

But one of the most useful things it has offered is rich material for the study of behavioural economics and finance – how human behaviour and emotions have a big impact on the financial world.

When it comes to investing, you need to be aware of what’s going on inside your head. If you are not, then you could end up with very disappointing returns on your money, says Michael Mauboussin in the Credit Suisse Global Investment Returns Yearbook 2014.

Why we keep doing the wrong thing

Conventional wisdom tells us that making money from investing is simple and straightforward: buy stuff when it’s cheap and sell it when it’s expensive – or buy low, sell high. But most people don’t do this, says Mauboussin. They do the exact opposite – buy high and sell low.

The reason for this is apparently due to the left side of our brains, known to neurosurgeons as ‘the interpreter’. It is normally good at working out the cause and effect of things, but gets itself into trouble when dealing with the random ups and downs of the stock market.

Investors end up putting too much emphasis on what has just happened and expect the same thing to keep happening. So if shares have gone up during the last year, they expect them to keep rising this year and put more money in the market.

When shares go down they sell in fear of losing more money. This behaviour has been christened by academics “the dumb-money effect”.

How this damages your wealth

Behaving this way can wreak havoc with your portfolio. Mauboussin used the example of a person who buys 100 shares in an investment fund when its net asset value (NAV) is $10 per share – an investment of $1,000.

During the next year the fund’s NAV doubles to $20 per share and the investor doubles their money to $2,000. Buoyed by the big gains they then buy 100 more shares, investing another $2,000 (100 x $20).

Next year the stock market crashes and the NAV of the fund goes back to $10 per share. Over two years the fund is back to where it was – its time-weighted return is zero. However, the individual investor has fared much worse by investing more money after the market has gone up.

You can work this out by calculating what is known as the money-weighted rate of return. This takes into account the performance of a portfolio when money is added or taken out of it and is based on an internal rate of return (IRR) calculation (see below for how to do this).

After two years the investor ended up with $2,000, having invested $3,000 – a money-weighted return of minus 27%. They would have been better off doing nothing or taking a ‘buy and hold’ approach.

The dumb-money effect explains why the returns quoted from the markets can sometimes be a long way from the reality of what ends up in investors’ pockets.

A study of 19 different stockmarkets in the March 2007 edition of American Economic Review showed that investors’ money-weighted returns were on average 1.5% less than the buy and hold returns from the market.

Mauboussin thinks that things might be worse than that. The average annual return of the S&P 500 index between 1993 and 2013 was 9.3%. Given that most average funds can’t beat the market, their higher costs mean that they return 1%-1.5% less than the market.

On top of that, the behaviour of investors means that they get 1%-2% less than the average fund – or 60%- 80% of the market return. If you are saving for retirement, can you really afford to behave like this?

What you should do instead

Remember that what happened in a market last year cannot predict what will happen this year. Don’t be afraid to buy and hold investments. Better still, keep your costs down with low-cost exchange-traded funds (ETFs). It is much better to spread your money around different types of investment and concentrate on where valuations are cheap (yields are highest).

According to Mauboussin the best guide to future long-term returns is going to be something based around their long-run averages.

The other things you can do to avoid the dumb-money effect are to decide how much of your money you will invest in different assets and regularly rebalance your portfolio (to get it back to its target allocation). This gets you automatically to sell a bit of what’s gone up (selling high) and buy what’s not done as well (buying low).

How to calculate money-weighted returns

It’s fairly easy to do in a spread sheet. Any money invested is a negative number. Money coming in is a positive number.

So in our example we have -1,000, -2000 (the investments made in years one and two respectively) and 2,000 (the value of the portfolio after two years). In Excel, use this formula: =IRR(A1:A3), where cells A1 to A3 contain the relevant numbers.

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