Emotions can destroy earnings
Have you ever wondered how much of the gains made by unit trusts actually end up in investors' pockets?
A lot less than you might expect, says Nic Andrew, head of Nedgroup Investments.
A comprehensive study done by the University of Michigan in the US concluded that dollar-weighted returns, the experience of the client, was consistently lower than the time-weighted returns, actual performance of the fund, over a range of markets and periods.
Over an 80-year period in the US, investors received 1,3percent less a year because they dipped in and out of funds at the wrong time.
The experience with higher risk markets is significantly worse, at 5,3 percent a year, says Andrew. The study also shows that as the investor holding period reduces over time, so the deficit increases.
So where is the performance lost, what are the reasons for the loss, and what can one do to avoid a similar fate?
"At first glance," says Andrew, "many would think the reason was excessive fees, strange performance reporting or some other shenanigans of investment companies."
The answer, however, lies in the enormous influence that emotion has on how we invest, the timing of when we buy and sell, he explains.
Nedgroup gives three main reasons that drive the shortfall, and they are all based on our behaviour:
l Fear and envy: Andrew believes that when one's investment declines rapidly - it is easy to panic - to sell and to move to a less risky strategy.
More difficult to understand, though common, is how some investors, having achieved splendid returns, are preoccupied with envy because their neighbour did better.
How does one counter these destructive emotions?
The key, says Andrew is to be aware of the damage they cause and to develop a sensible framework with realistic expectations before investing.
It is an unfortunate reality that returns in excess of cash go hand in hand with the risk of losing money.
l Noise: This is principally generated by the marketing machines of the investment companies and the headlines in the financial press.
Their respective jobs are to gather assets and sell newspapers, and nothing sells better than superlative recent performance.
In fact, says Andrew, specific fund advertising and newspaper headlines are often an excellent contrary indicator.
l 'Agency' effect: This refers to the pressure a financial adviser, multimanager or trustee, faces from their clients in their role as investment expert.
Andrew believes that these agents are regularly responsible for selecting and monitoring investment managers, and making asset allocation decisions.