Don’t chase the value trend

You probably already know that many actively managed funds consistently underperform the market. However, one group underperforms even these funds the private investors who put their money in them. The annual Quantitative Analysis of Investor Behaviour (QAIB) report, issued by US financial services research group DALBAR, looks at the actual returns investors make, compared with the returns reported by the funds they invest in.

QAIB finds that investors underperform by as much as 6% a year. Others dispute the specifics of DALBAR's methodology but they still find private investors underperform on average. This also holds true across investment styles. Jason Hsu of Research Affiliates, an investment firm, found that between 1991 and 2013 investors in US value funds (which managed to beat the market as a group) earned an average of 1.31% less per year than the funds themselves. Even after controlling for fund fees, investors fail to keep up.

So what's going wrong? Value investors are supposed to "buy low, sell high". But Hsu's research on fund flows shows there are more "trend-chasing" value investors than buy-and-hold ones. In other words, they trade in and out of the funds in an effort to time the market. Trouble is, they're bad at it. Rather than "buying low" (after value funds have hit a dull period), they buy when the funds are outperforming, and sell when they hit rock-bottom. By buying high and selling low, they "routinely wipe out all, or more than all, of the outperformance produced by value-oriented managers".

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Growth investors did even worse, underperforming growth funds by 3.16%. Also, investors who hold the most costly funds (who, Hsu argues, are probably less sophisticated than their more cost-conscious peers) made even worse timing decisions, underperforming by 4% a year. So smarter investors do better than naive ones. But both do worse than simple buy and hold.

What can you learn from this? Firstly, if you really want to time the market, you mustn't chase performance. If you buy a hot sector, you are by definition "buying high". It might go yet higher, but why risk it? Instead, look for unloved areas. One good rule of thumb is that a good investment rarely feels comfortable.

If you'd rather (sensibly) avoid market-timing, an alternative is to come up with your asset allocation (how you split your wealth between UK stocks, Japanese ones, bonds, etc). Then, as your portfolio deviates from its original allocation, "rebalance" by taking profits on sectors that have risen and buy more of those that have fallen back. It might seem like less fun, but the odds are that it will make you more money in the long run.