Got any more good investment advice?

Phi Kappa Phi Forum, Spring 2003 by Chambers, Larry

Never have so many Americans experienced such control over their financial futures, yet felt such a need for help. Investors are running scared, abandoning growth and value strategies, and instead, are putting money into annuities, bonds, and money-market funds. It seems that they always do exactly the wrong thing in a very predictable way. The chart below is a good example.

This chart shows thirty-year U.S. Treasury-bond yields and their relationship to bond mutual-fund sales. Because yields and bond prices are inversely correlated, bond prices are high when yields are low. You would expect investors to buy fewer bond funds when bond prices are high, but that is not what bond mutual-fund sales figures show. Investors did the opposite. In almost every peak and trough of interest rates during the past eighteen years, investors did exactly the wrong thing!

Behavioral-finance researchers note that when investors react to new information, they frequently move in the wrong direction and do the wrong thing at the wrong time.

Paul Andreassen, a psychologist at Harvard, has studied the relationship between the news media and investing. In one experiment, Andreassen separated people into two groups: the first group bought and sold stocks solely on recent price data; the second group traded after being given the price data plus news headlines that explained the changes. When stock prices were volatile, Andreassen found that the group that had access to the news headlines earned less than half as much per share traded as the group that received only price data.

WHY NO NEWS WOULD BE GOOD NEWS!

Andreassen theorized that people tend to consider news reports almost as predictions. When a jump in a stock's price is accompanied by news that seems to support the price movement, we take that as a sign that the trend will continue. Conversely, when news reports justify a price decline, we tend to take that as an indication that the negative trajectory will prevail. As a result, we are likely to buy, buy, buy when the news is good and sell, sell, sell when the news is pessimistic. With thousands of investors reacting this way, stocks can be artificially driven to unrealistically high - or low - levels.

During 1990, numerous stories were published about how our stock market would collapse if and when shooting started in the Middle East. But what actually happened as the missiles started to fly over Baghdad on January 17, 1991, is that the stock market started soaring as well.

Then in 1995 the argument in the media was, "Stock prices have been rising for far too long, and a huge correction will obviously soon occur." As proof, we were told, just look at the uncanny resemblance between prices in the summer of 1995 and in the summers of 1929 and 1987, and the subsequent collapses in October 1929 and October 1987. "So get ready," the media warned; "it's going to happen again." But once again, the markets did not collapse; in fact, until recently they continued to rise.

Yet, we appear to have no memory of these predictions and succumb to each one as though it were factual. Consumer magazines are not research packaged to help investors make unbiased decisions. They are in business to make money for their owners and advertisers. And sometimes they do neither: they disappear. Recently, Red Herring, which had employed 200 people during the internet boom, closed its doors, joining Mutual Funds magazine, Individual Inestor, Family Money, Consumers Digest, Your Money, and On Line-Investor - all gone, along with their advice, predictions, and profiles. Even Worth magazine plans to publish only on a limited basis.

Money magazine formerly published an annual "seven best mutual funds" series. In each following year, the prior "best funds" underperformed the S&P 500. Money editors stopped this exercise after a few years, I suspect because they sensed that somewhere, somebody might actually hold them responsible for their recommendations.

THE HERD MENTALITY

A study by Dalbar, the Boston-based consulting firm, tracked the gap during several years between investor performance and market performance. Dalbar's data show that for the fifteen years between 1984 and 1998, the average equity mutual-fund investor received an annualized return of 7.3 percent, and the average fixed-income-fund investor received an annualized return of 6.3 percent. Yet, during this same period, the average equity mutual fund returned 13.5 percent annually, and the average fixed income fund returned 8.6 percent. In other words, the funds showed strong performance while investors in those funds actually lost money! How could this be?

There is safety in numbers! Investors poured money into sectors or mutual funds after they heard about significant performance gains. Then, as performance flattened or declined, they moved on to look for the next hot sector. They bought high and sold low. Not only did they miss out on good performance but also, in many cases, they incurred trading costs and tax consequences that set them back even further.