Are You Your Own Worst Enemy?

May 21, 2015

 

In a recent article in the Wall Street Journal, author Liam Pleven addressed research studies that offer new evidence that investors are often their own worst enemy.

 

The three behaviors studied were (1) making off-the-cuff decisions, (2) being prone to biases, and (3) being swayed by market moves.  Those all sound like common place occurrences, and investors are guilty of all three.

 

One of the new studies found that both individual investors and mutual fund managers are more likely to sell stocks that are either the biggest winners or losers in their portfolio. The author of this study, Samuel Hartzmark of the University of Chicago dubs the phenomenon the "rank effect". Amazingly, he found the rank effect shows up in tax deferred accounts, suggesting that the sales of an investor's biggest losers can't be attributed to realizing losses for tax purposes.

 

The research indicates the rank effect is often used as a quick and dirty way of deciding what stocks to sell.  Hartzmark concludes that knowledge of this effect might make it easier to overcome.

 

Another study found that investors put less money into mutual funds managed by people with "foreign sounding names" than in similar funds run by those with more American sounding names.

 

The same researchers also found that investors, when presented with a choice of investing in a mutual fund tracking the S&P 500 index, invested more with an American sounding name as the manager, even when the costs were higher!  One of the co-authors, Alexandra Niessen-Ruenzi, a finance professor at the  University of Mannheim in Germany suggested, "a rational investor should always pick the cheapest fund".

 

The third study found that investors put more money into mutual funds where the share price of the parent fund company was outperforming. Fortunately some of the biggest and best mutual fund companies are not publicly traded, including Vanguard, Fidelity and Dimensional Fund Advisors.

 

Benjamin Graham in his classic book, "The Intelligent Investor" stated, "We have seen much more money made and kept by ordinary people who were well suited for the investment process than those who lacked this quality, even though they had an extensive knowledge of finance, accounting, and stock-market lore".

 

So, it seems some soul searching is in order for investors.  A low cost broadly diversified portfolio with occasional rebalancing is likely the answer.

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