Investor Behavior Impacts Returns
Here are some key takeaways from “Investor Behavior Impacts Returns”
– Investor behavior (panicking, selling quickly, over-trading, etc.) tend to lead to poor returns, especially from from volatile funds
– Frequent trading and attempts to time the market generally lead to worse investment outcomes
– These attempts to trade are usually due to investor behavior (selling at a bad time)
– Rebalancing should be rules-based and countercyclical. But this is difficult for investors to implement in practice
– Treating investing as entertainment often leads to underperformance compared to buy-and-hold strategies
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Jeff Ptak – Substack Article
Posts by Jeff Ptak on Morningstar
Investor Behavior Impacts Returns – Transcript
So today we’re going to talk about an article from Jeff Ptak, who writes for Morningstar. This article isn’t yet published to Morningstar, but I think will be soon. This is Jeff’s side hustle. We’ll link it up, but this was just from SubStack.
1. The Gap Between Total Return and Dollar-Weighted Return
Jeff took a similar look for Morningstar’s Mind the Gap study, which looks at the perils of trying to time the market. They published that once per year. We usually talk about it because it’s a great message that we like to deliver to folks.
Jeff took a slightly different look at things. He basically wanted to look at the gap between funds total return and their dollar weighted return and see the discrepancies between there. The dollar weighted return is basically a measure of when people were trading in and out of the funds.
He broke it down in a good chart. I don’t know if we want to pop this up in the video, but kind of just walk us through it here. The least volatile funds that he looked at were the total return and the dollar weighted return were equal. There was no gap, but as you get further out, so the more these funds are traded or the more volatile they are, the bigger the gap becomes.
It gets at its worst to not quite a negative 3%, so a 3% gap. That is created from people just trading in and out of funds or making poor timing decisions, that’s at its worst is just about 3%. But it is, he breaks it out into different quintiles, so each group – besides the least volatile group – has some gap or some negative impact on the investment outcome from trading these securities and trying to time the market.
2. Volatility and Market Timing: A Correlation
Not a new message here – that timing the market is extremely difficult. But a new way to look at it.
I think it makes sense too, when you think about it, like the ones being traded the least are the ones that are the least volatile. They’re not swinging violently with the markets up and down each day, they’re just being less volatile. They’re…
3. The Temptation of Volatile Assets
They’re less temptation.
Yeah, exactly, less temptation. Like if you’re watching this every day and you’re watching it move a lot, you’re, I think, going to be naturally inclined to trade more if the volatility is higher.
And that also, I think as the chart confirms; it presents the opportunity for that timing to go poorly. Which on average, we know that it does.
It’s not to suggest that nobody can get a timing trade right once or twice. But on average we shouldn’t expect to.
And that’s probably why we try to avoid that as much as possible when it comes to an investment approach.
4. Morningstar’s Previous Findings on Investor Behavior
I think this ties in nicely with the other work that Morningstar – and Jeff Ptak in particular, have done. In the sense that this gap that exists between what returns are posted by funds year over year – is not really what individual investors are actually getting.
And that’s because they get a little bit of a trigger finger. They’re moving in and moving out. And so I think as he suspected before he began his deep dive into this, is that the folks where the funds where they’re seeing more net inflows and outflows, more change in the ownership of these funds — those folks are actually getting lesser returns.
They’re getting lesser returns because they’re selling them when they’re down. And they’re buying them back higher. Which you know is “timing the market.”
5. The Trap of Buying High and Selling Low
That’s the trap that we run into. I know when Morningstar breaks it out, they look at the different types of funds as well, and you see like an allocation type fund like a target date fund in a 401k.
Usually is very close to what just the buy and hold, the actual return there. But when you break it out to like sector funds, the gap gets even wider to like, I forget the specific number, but it’s more like a 4 or 5% gap. So I, you know, the more specific the type of fund is, the higher the likelihood that there will be some sort of performance gap there.
I think it also makes sense too because if you think about, or something else that we’ve seen over the years is that this volatility when things are swinging one way or the other, a lot of times the biggest up days are followed, or they follow some of the biggest down days.
So down days and up days tend to get packaged together like that.
So if you’re selling out during a down day, like what we saw last week. You’re probably going to miss some of that upswing because by the time you want to get back in and you feel comfortable to get back into the fund, things have already rebounded.
We saw a lot of that in 2020.
We had some massive down days followed by almost as massive up days just the next day or a couple days after that. So it’s really hard to sell out and then “get yourself composed” to buy back in – less than a week later…
Not gonna happen!
So it makes sense why you see those negative returns, so to speak, for investors. It’s poor investor behavior. They’re just, they’re not getting the returns, because they just sold out a few days ago and then you’re seeing a volatile swing back in the other direction – just a few days later.
6. Historical Perspective: Mutual Funds vs. ETFs
Funny to note that in the 80s and even into the early 90s when ETFs really didn’t exist… the only way you could really do this was trade mutual funds.
And mutual funds would have a longer settlement. And so you would sell out, like Tim said, on a big down day. And you really didn’t even know the price you were going to get. Because you had to wait for the market to close.
And then the funds were not available to buy back the next day.
Couldn’t get back in even if you wanted to, and people likely don’t even want to, but yeah, you couldn’t.
I don’t think we have this data. And just something that I thought of – based on your mention of mutual funds and ETFs and their lack of existence at that time.
People have been doing this stuff since the dawn of time.
So before funds even existed, they were just doing this with individual stocks.
Because if you look at the data, it’s suggesting that the more volatile “the thing” is, the more people are likely to trade it.
So I would put individual stocks – if we had the data – probably at the top of that list – in terms of how often people are tricked into trading as a result of volatility.
And I think that Casey’s point about the target date funds being towards the bottom of that list makes sense too.
Because when you think about a diversified portfolio, you’re always gonna have an individual part that you can nitpick. If you remove that from the conversation and you just have a target date fund, you have a portfolio overall that’s giving you the aggregated performance across the different, the parts that make it up, the components.
So you’re gonna have less, less distraction, to see “this individual part is not working.” I think that you can probably just write the cyclical nature of all of those parts together better by considering the portfolio as a whole.
But we don’t tend to do that.
So this doesn’t suggest that you shouldn’t own volatile funds as a piece of your portfolio. But I think that it does suggest that people are probably owning them in the wrong proportions relative to the risk tolerance and what their goals are. Again this points to investor behavior.
And that’s why they’re freaking out and selling these things and buying these things at the wrong times.
Timing the market dates back to the age of man. We’ve got the fire, we’ve got fire, the wheel, and timing the market.
I think so. I think so.
To your point, a little bit more there, Brendan, I looked at one of Jeff’s pieces from Morningstar, and this was written at the end of January, so about 6 weeks old at this point, but he looked at if we’re assessing the overall split between stocks, bonds, cash in a portfolio.
Then, coming off of two really good years in the market, what are the average allocations looking like?
So, historically, it’s about, let’s see here. It’s about a 75/25 split across all investors, meaning 75% stocks, 25% bonds.
But what Jeff found (when he wrote this at the end of January), was that actually became 78% stocks and 22% bonds, which was the highest reading going back to 2015 in terms of stock allocation in a portfolio. And that’s due to market performance.
And that probably felt pretty good in November, December of 2024 being having more stocks than bonds – because they were doing well.
But now it’s coming around the other side.
And also within that, he looked at US equities versus international equities and the split between that and, typically it was around 75% stocks – errr US stocks – within the overall stock allocation and 25% foreign stocks.
But he found in January that that got to 82% US stocks and 18% international stocks.
Wow. That’s a big huge gap.
A big overweighting there. And I think, to your… it’s NOT that we’re saying to “not own volatile assets” and to “never trade” your account, because I think rebalancing your account back to target allocations — as long as your lifestyle or your life circumstances hasn’t changed — is probably smart.
And something you should be checking in on, maybe once or once a quarter or 2 times a year, or something like that.
I think that also says to me though that doing that is is “easier said, than done.” And having a rules-based approach is good and easy to have on paper, but it’s hard to do. Difficult for people to enact in real life.
That’s because, like you said, part of it is market performance. But shifting the overweighting towards stocks and domestic stocks.
But I feel like part of that has to be people’s just – you know, “why do I need to rebalance? I don’t need to rebalance right now.”
That’s “recency bias!” You know, “what’s done well lately,” and not considering what the implications are for future returns.
You know, how much what that does to the risk profile of the overall portfolio.
7. The Importance of Countercyclical Rebalancing
Good rebalancing, good rebalancing is countercyclical. It’s not going to feel good.
If you’re calling it a “rebalance,” and you’re not doing something that’s countercyclical, then you’re just using rebalancing as as a euphemism for trading and market timing, I think.
I think having rules-based rebalancing removes the drama and the entertainment. And let’s face it, we know some people where that’s really WHY they invest. They like the drama. They like the entertainment factor that comes with, as Brendan likes to say, “number go up!”
Yeah.
I think the cost for wanting your investments to be entertainment – are the unflattering investor return statistics that we shared at the onset.
Like, you’re probably gonna underperform the funds that you own by a certain amount each year. And if that’s worth being entertained to you, that’s fine.
But I don’t know that you should have any, you know, expectation that you’re going to outperform regularly by trying to time the market.
That’s all I had. I know it’s a tried and true message. And I think it’s kind of like “feeding people their vegetables” and and doing the countercyclical rebalancing and not trying to time the market, but…
What’s a vegetable?
Or, steak, in your case.
That’s all we’ve got for this episode, investor behavior impacts returns.
Thanks as always for tuning in.
