Market volatility and investor emotions lead to under-performing investment portfolios
Courtesy ANB Bank, Colorado Springs LIVING WELL Magazine
Over the last 30 years, a number of studies have been conducted that compare the investment performance of professional money managers (also known as institutional managers) with that of self directed or individual investors. The evidence suggests that on average, institutional returns have been approximately three times better than returns generated by individual investors whether investing in stocks, bonds, or both
This is not the result of institutional investors having access to information that individual investors cannot attain or institutional investors getting information sooner (either would be illegal) or that professional money managers are smarter than the average investor. The difference in performance is attributable to three things: diversification, re-balancing, and patience. The institutional investor has a process in place that implements asset allocation (not putting all your eggs in one basket), a systematic method of rebalancing (this keeps your portfolio from getting over-weighted in one particular asset class) and most importantly patience to stay the course when the markets are moving sideways or experience unexpected corrections.
Most investors are emotional when it comes to their wealth. They get excited when markets have trended upward for a while and panic when markets see a correction. This leads the markets to be driven by fear and greed.
The self-directed investor has a tendency of reviewing their statements (after a quarter or sooner), looking at what has done well and what has done not so well and then moving more money into the assets that have just done well and away from the laggards. This leads to under-performing portfolios as asset styles revert to their historical mean. The problem is compounded as portfolios become over-weighted in particular asset styles, creating a situation where the portfolio does not reflect the investor’s financial objectives and risk tolerances.
The volatility in the equity markets over the last five years has brought attention to indexes that measure volatility or the perceived fear in the equity market. The main index that has garnered the bulk of the attention over the last couple of years is the Volatility Index (VIX), which roughly measures the level of investment fear in the S&P 500. In my opinion, investors attain a high level of fear when the VIX reaches a level of 40 or higher. This has happened six times in the last 15 years (see chart below). Investors begin to see the markets declining, panic and liquidate their equity positions. Unfortunately, they tend to do this at the very point that equities are bottoming. Each of these episodes of panic selling has been followed by periods of exceptional returns averaging 54% with the smallest rally being 24%. The VIX recently hit 40 again, marking both an elevated level of fear and possibly a bottom in the equity markets.
The recent volatility in the equity markets have caused investors to flock towards the bonds and other vehicles that are deemed to be safer. They ignore that rates have been declining for the last 30 years and that this trend cannot continue much longer. A 10-year treasury trading below 2% is the equivalent of a stock trading at a price/earning ratio of 50! How many stocks would you buy that have a P/E ratio over 50? Investors seem to be ignoring the yield of the S&P 500, which is above 2.25% and its P/E ratio of approximately 12 times next year’s earnings.
Remember, three things are needed to attain the investment returns garnered by institutional investors, diversification, rebalancing and most importantly, patience. Buffet’s adage rings true: “When investors get nervous I get excited and when investors get excited, I get nervous.”
So the next time you are making a decision related to your investment portfolio, ask yourself: Am I making this decision based on the fundamentals of portfolio management (diversification, re-balancing and patience) or am I making it based on fear or greed. If the answer is the later, history has shown that the result tends to be not in the investor’s best interest.