Investor Behavior

Business - October 6th, 2006
Magellan Japan

Tel. 03-3769-5511

Stick it out for better results

A recent research study concluded: “Investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who simply remained invested earned higher returns than those who attempted to time the market.”

Given that the average investor seeks the best-performing investments to suit their situation, shouldn’t the average investor achieve at least the av­erage investment return? The answer is quite simple—it all comes down to investor behavior; investors do not always make the most rational decisions. The average investor has the tendency to purchase or increase their holdings in investments that perform the best in the short term. At the same time, these same investors tend to sell or re­duce their holdings in investments that have performed poorly, again, in the short term. As a result, just prior to a market correction, the average investor will hold a portfolio that is heavily weighted in asset classes that have demonstrated the best short-term performance.

It appears to be human nature to
make changes during declining markets.

Since a large proportion of monies have been added to these investments after most of the growth has oc­curred, this strategy leads to a dramatic decline in their portfolio when the market corrects. During a stock market correction, investors tend to panic, believing that they will lose all or most of their money, and so the most common reaction is to sell to “cut their loss­es.” This behavior drags the market down further than fundamentals suggest—it is a self-fulfilling prophecy. It is during these times that we hear statements such as “I should have left my money under my mattress,” and “Investing is like gambling.” Investors need to analyze their portfolio as a whole, rather than spending too much time worrying about individual investments.

To further complicate matters, the market does not react in a predictable manner over the short-term. The important point to keep in mind is that these short-term stock market trends have nothing to do with the underlying investment climate. Trying to predict short-term movements in the market means trying to predict investor sentiment, which is nearly impossible; it has nothing to do with the underlying value of the stock market in the long run.

It goes without saying that investors need to take the time to understand their person­al risk tolerance before investing. If you invest in a portfolio that is too aggressive, then during the inevitable stock market correction, you will be tempted to make changes to your portfolio, thereby guaranteeing a loss. It appears to be human nature to make changes during declining markets.

When adjusting your portfolio, you always want to make changes from a position of strength such as dur­ing a rising market. Can you predict the best time to make the changes? Not likely, but you will be making these changes while you are in a profitable position.