Recent Investment Association fund flow data make for interesting reading. According to the IA, net retail outflows hit £399m in February whilst in January UK funds suffered net outflows of £437m – the largest figure since the 2008 financial crisis. Targeted absolute return was the top-selling IA sector in February with net retail sales of £243m – its best performance since October 2015.
What are we to make of this? January and the first half of February were horrible months for world equity markets as investors worried about China, oil prices and the possibility of a US recession – so from a behavioural perspective it’s unsurprising that retail investors sold equity funds and bought more defensive absolute return funds as fear set in. However, given the sharp market rebound in the second half of February (and continued on in March) this behaviour turned out to be exactly the wrong response.
Is it fair to criticise investors on the basis of one data point though? No. But based on more comprehensive evidence, it actually does turn out that investors are pretty bad at timing the markets.
Russel Kinnel, Director of Mutual Fund Research at Morningstar, does a yearly comparison between the quoted performance of mutual funds in the US (the return on $1 invested at fund inception) vs the returns investors actually achieve investing in those same funds. Why is there a difference? Well, investors don’t in reality invest $1 at the inception of a fund and hold it. In reality they buy and sell funds over time and they tend to invest after a fund has performed well, and sell when a fund performs badly. What Kinnel measures as true investor performance are the returns earned by the total pool of investor money, with bigger funds (with more money invested and thus a bigger effect) being more important than the performance of smaller funds with less money invested.
And the results? Whilst the exact period of measurement affects the results quite dramatically, Kinnel has found that on average US investors’ timing decisions cost them about 1.3% a year. And lest you think that this only applies to US investors, a 2010 working paper for Cass Business School put the number for UK investors at 1.2% a year for the 9 years up until 2009.
Is 1.3% a year significant? Yes. Over 25 years, subtracting 1.3% a year from an annual performance of 5% a year results in a lump sum portfolio that is about 27% smaller. Or put another way, an extra 1.3% a year in this case would allow an investor to buy a 36% bigger annuity income.
So what does this all mean? Well, overall investors are pretty hopeless at timing the markets, as they tend to follow a range of emotions during a normal investment cycle that can cause them to make bad investment decisions. In general they would do much better if instead of chasing returns and investing emotively they stuck to a more consistent investment approach. This is definitely an area where a good adviser can add a lot of value by helping the client choose an appropriately risked portfolio and coaching them to stick with it. And PortfolioMetrix, by supporting that adviser through the provision of our innovative financial risk assessment tools and tightly risk-mapped, research based, discretionary portfolios can play its part too.
Clare & Motson (2010) Do UK retail investors buy at the top and sell at the bottom? (working paper) Centre for Asset Management Research , Cass Business School