« The Performance Paradox - Fear - (Part 1) | Main | The Performance Paradox: The Antidote (Part 3) »

January 17, 2008

The Performance Paradox - Greed - (Part 2)

Last week I wrote about what I call the Performance Paradox. The Performance Paradox is: The more you want or need it, the more you try to get it, and the more you micromanage it, the worse it will be.

 

There are two sides to the Performance Paradox. One is fear, which I discussed last week. The other is greed. Let's see how these two work together to decimate investor performance.

 

John is a 45 year old employee of a defense contractor here in town. His company offers a 401(k), which he maxes out each year. John characterized the performance of his 401(k) as "awful" and his performance as the manager of his 401(k) as "mediocre at best."

 

"Why do you say your 401(k) is awful?", I asked.

 

"I keep hearing how the Dow is at an all-time record high but my 401(k) is nowhere near an all-time high. I must be doing something wrong."

 

"How do you decide what funds to pick within your 401(k)?"

 

"I pick the one with best track record over the last couple of years?"

 

"Only one?"

 

"Yes. I go for the one going up the most. But as soon as I get in them it seems like they stop going up."

 

"So then what do you do?", I asked.

 

"I sell them."

 

"And then how do you pick the next one?", as if I didn't know the answer.

 

"The same way."

 

It didn't take a lot of detective work to spot the cause of his sub-par returns. His portfolio decision-making was being driven by greed. Of course, this process for picking investments flies in the face of what we know to be true - namely that markets are cyclical. Trees don't grow to the sky and all investments go through periods where they do well and others where they do not so well.

 

So take a mutual fund that has out-performed the market in each of the last three years. People start to notice. The fund manager gets written up in Barron's. The fund makes a bunch of lists in magazines like Smart Money and Forbes, with titles like "The 10 Funds You Must Own This Year Unless You Want to Be Poor and Stupid" and money comes pouring into the fund from people like John.

 

This is great news for the fund company - big cash inflows - exactly what they hope for. They make a lot of money and the fund manager gets a multi-million dollar bonus.

 

But it is bad news for the new investors like John. It’s a death knell. Big inflows are a contrarian indicator. They almost always signal the end of the run.

 

What John does not consider is it is absolutely impossible for the above average performance to continue indefinitely. The aggregate return of investors is the stock market return less transaction costs. There is no persistence in stock market returns. The funds which do well in any given period are typically the worst performer in subsequent periods. In short, the results are basically random.

 

So driven by greed, John buys the hot fund. When it fails to meet his unrealistic expectations, as it inevitably will, he sells it. What has he just done? Bought at the top and sold at the bottom. If you look at the fund's performance on Morningstar it will seem to have done quite well. Look at John's performance and it won't be anything close.

 

This pattern is well documented in an annual study by Dalbar called the Quantitative Analysis of Investor Behavior or QAIB for short. What the QAIB tells us is that in any rolling 20 year period the average investor underperforms their investment by a significant margin because of a persistent pattern of buying high and selling low.

 

This pattern can be driven by greed, as in John's case, or by fear, as I wrote about last week. Either way, the result is the same.

 

What is the answer?

 

The one thing I know for sure about investing is to make money over the long run you have to stay put. Successful investing requires discipline and patience. As I said last week, investing in the stock market is a winning strategy over time, just not all the time.

 

The investor who moves in and out of various investments because the one they are in now doesn't feel good or because they think the grass is greener somewhere else will always get the opposite of their intended result. That is the Performance Paradox.

 

Next week, we'll talk about the antidote. Stay tuned.

 

Kim Snider, Kim Snider Financial Communications, Chronim Investments and/or Snider Advisors make no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments are subject to risk including possible loss of principal.

Posted by Kim Snider on January 17, 2008 | Permalink