Are you tempted to buy that latest mutual fund you saw advertised on TV? Beware, it can be costly. And you probably don’t have a clue just how much!
Ask the average person how to make money in stocks and they will tell you to, “Buy low and sell high.” Sounds easy enough, particularly when you consider that we generally practice that behavior in everyday life. We buy clothes when they are on sale. We might eat steaks when the supermarket runs them on special.
You’d think this behavior would transfer to investing. In fact, it’s more likely that just the opposite occurs- we are more likely to buy high and sell low when investing. Weird, huh?
Consider a mutual fund you hold that made money last year, say a 7 percent return. You were reasonably pleased with this performance. But while at the grocery checkout counter (buying steaks on sale!), you see the cover of the latest financial magazine. It features a mutual fund manager that earned 30 percent last year.
Now your fund doesn’t look so good. So, you sell it and buy the fund on the cover. This is chasing performance and it works against you in a couple of ways.
First, when you buy the fund with the recent 30 percent return, you are likely “buying high.” The fund may have been in a particularly hot asset category for that year, say small cap value. But the 7 percent fund you owned was large cap growth, a category that didn’t do so well that year. Top performing asset categories vary from year to year, so you may have sold the large cap growth at the wrong time. So not only are you “buying high” but you may well be “selling low.” Exactly the opposite of what you should be doing.
The motivation to trade your fund may come from a financial magazine, or from CNBC, or your broker. We are bombarded with information telling us how good other investments are doing. The temptation to trade our current investment for others “doing better” is strong and often wins out. But let’s look at the cost.
Dalbar, a premier research company on mutual funds, annually measures the difference between actual investor returns and the returns of market indices. Dalbar consistently finds a gap of 4 to 6 percent in returns with investors underperforming the indices by wide margins. Investors impatient with one fund invariably traded to another, buying high and selling low. Sounds incredible, doesn’t it, to sacrifice that much of a return by trading?
Morningstar has done similar studies and found similar results, further demonstrating that chasing performance is decimating to your returns. Top performing funds attract lots of new money, new money that is “buying high.” And the money is often coming from unfavorable investments, investors who are “selling low.”
The cost of chasing performance over time is huge. Consider a buy and hold investor that invests $4,000 per year over 30 years and earns 7 percent annually versus an impatient performance chaser that earns 3 percent annually over that same period. The 7 percent account accumulates to $378,000. The 3 percent account has grown to just $190,000!
Your takeaway: Set your investment game plan based on sound principles of diversification and your acceptable level of risk. Then stick with it to achieve your objectives. Avoid being distracted by the barrage of media noise and hot tips and it will pay off handsomely over time.
Dr. David Ashby is a Certified Financial Planner and the retired Peoples Bank Professor of Finance at Southern Arkansas University. He holds degrees in accounting and business administration and a doctorate in finance from Louisiana Tech.