Herd Behavior Hurts Fund Investors

Jason Hull
November 5, 2012

When I was growing up, I was a nerdy little kid. I wanted ever so desperately to be one of the cool kids. I tried to do anything-- within reason and without invoking the wrath of angry parents--to be popular. I followed the cool kids. I did what they did. I blindly accepted anything they asked me to do. I still wasn't popular. It didn't matter. I kept on blindly following in hopes that, I, too, would one day be one of them.

It seems that mutual fund investors have some of that same misguided desire. The Investment Company Institute recently released its measures of mutual fund asset flows--how much investors are either putting into or taking out of mutual funds. Based on data dating back to 2007, investors in mutual funds haven't yet received the message that it's smart to buy low and sell high. They're often doing the opposite.

I evaluated the data on a monthly basis to determine if fund investors, as a whole, had mastered the concept of market timing. In the 68 months between January, 2007 and August, 2012, the mutual fund investors managed to either sell on a market decline or buy after the market had risen 57.4 percent of the time. Here's how the timing broke out:

--Sold on dip: 29%

--Bought on rise: 28%

--Bought on dip: 16%

--Sold on rise: 26%

You would have been better off flipping a coin to determine whether to buy or sell in a given month.

Now, if these investors had been off with their timing but made bigger bets at the appropriate time, this wouldn't be a problem. If I lose $10 when I'm wrong, but make $100 when I'm right, then I can be wrong much more often and still wind up ahead. Unfortunately, investors also got the magnitude of their investments wrong. They sold more when the market was down and bought more when the market was up rather than the other way around.

How much did this cost mutual fund money chasers? During this time period, the S&P 500 was effectively at breakeven when adjusted for dividends; it lost 0.13 percent. However, due to outsized selling during bad times, equity mutual fund investors, as a whole, lost 35.8 percent when adjusting for dividends. The worst contributor to this performance was the market's reaction during the time period from October 2007--when the S&P 500 had just hit its high for the time period of this study-- through February 2009--when the S&P 500 had just hit its low for the time period of this study. During this time, the S&P 500 lost over half of its value. What did investors do? They sold, en masse, with $245.5 billion flowing out of mutual funds. During the time period of the entire study, $364.9 billion left mutual funds, so 67 percent of the money left the market during its worst 16 month period of performance.

What can you do to avoid following the herd and exacerbating a bad situation?

Keep an appropriate time horizon. Your age and saving habits matter more your investing prowess. If you have an appropriate time horizon and have appropriate asset allocation to match your risk tolerance, stay the course. Oversteering is only going to lead you to trouble.

Don't check stock quotes all the time. Every time you check a ticker, you're going to start second-guessing. You're going to wonder if you should take profits now or sell because the market is dropping. You can't time the market. Don't try. If the professionals can't do it, retail investors will do worse.

Dollar value average. Dollar value averaging is a slightly different take on periodic investing. Rather than investing the same amount every month, you invest more or less depending on how the market has performed. If the market is down, you invest more, and if the market is up, you invest less or sell. This approach, in the long run, is more likely to enable you to buy low and sell high.

I eventually learned not to care what everyone else thought and found my life was much simpler and less stressful. If you can learn not to worry about what the herd is doing in the market, you, too, won't be chasing performance and will probably sleep better at night.

Jason Hull is a candidate for the CFP(R) Board's certification, is a Series 65 securities license holder, and owns Hull Financial Planning.

More From US News & World Report