Can too much investment activity jeopardize your financial health?

Does it seem that everybody is making money on their investments except you? Do you feel that you are continually missing out on the hot investment trends?

Unfortunately, you are not alone. Many investors are inclined to question their investment strategy based on media reports and friends’ claims of what appear to be guaranteed methods of making superior returns.

Studies verify activity produces poor results According to a recent US study completed by the Chicago-based research company, Morningstar, investors tend to pour money into equity funds on market upswings and sell on downturns. This approach has led to equity fund returns that are significantly lower than their advertised results. The difference is the result of the length of time shareholders held onto their fund shares and the timing of their purchases and sales.

These findings are not new. Dalbar Inc., a Boston-based financial services market research firm, conducted the first study of this kind in 1993 and has repeated it several times. It examined monthly cash flows in and out of both stock and bond funds; average length of time shareholders remain invested in a fund; and volumef sales and redemptions. Dalbar’s research repeatedly determined that investors actively buying and selling mutual funds tend to experience poor results. Using exquisitely inappropriate timing over the 20 years to 2004, the average stock mutual fund investor earned a 3.5 per cent annualized rate of return as compared with an annualized gain of close to 13 per cent for the S&P 500, a passive index.

Moreover, during other periods, returns from equity funds barely beat inflation, with the exception of 2005 when, for the first time in at least 21 years, average equity fund investors managed to beat the index. However, Dalbar indicates that this may be an anomaly.

In fact, using what it calls the “guess right ratio,” the study found investors were about 75 per cent more likely to guess the direction of the market correctly during rising markets but less than 50 per cent during falling markets. Being accurate in strong markets however, fails to compensate for being wrong more than 50 per cent of the time in down markets. This conjecture in the form of market timing has resulted in a substantial drop in investors’ relative performance.

Gap between official and dollar-weighted fund results
Morningstar analyzed the returns for all US stock funds with ten-year records, highlighting the gap between the funds’ published results, that is, the returns investors would have made had they stayed in that fund for the entire period and their dollar-weighted returns over the same period. Dollar-weighted returns take into account how the fund performed based on its level of assets, and are a more accurate reflection of investors’ actual returns.

Among diversified categories, the study showed that the gaps were largest among growth funds. For instance:

  • The ten-year annualized dollar-weighted return for the average large-growth fund was 3.4 per cent lower than the stated return.
  • The gap was 2.5 per cent for mid-growth funds.
  • It was 3 per cent for low growth funds.
  • Sector funds saw the widest gaps. For example, the dollar-weighted returns of technology funds lagged official returns by an average of 14 per cent.
  • The considerable disparity was caused when shareholders rushed to purchase growth and technology funds in late 1999 and 2000, then cashed out their shares when the tech market collapsed a few years later. Large value funds reflected the smallest gaps at 0.4 per cent since they were less volatile and posted steadier returns. It appears that shareholders are more liable to remain with a fund that posts stable returns than one that bounces around, regardless of the overall results. For instance, the average large-growth fund had a standard deviation of 19.3, which is much higher than the 14.6 of the S&P 500. The more volatile a fund, the more probable it is that investors will be attracted to it motivated by fear or greed.

    When designing your portfolio, it is important to seek stable returns as opposed to high gain and uneven returns. Investments that can provide steady income and growth in most market conditions should be your choice. As frequently stated in these reports, people are not usually successful in pursuing yesterday’s winner. Just because your friends seem to be making more money that you in investments, keep in mind that these are often the same friends who claim to always win at the casino. Yet if this were true would their house not be bigger than the casino?

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    This report is written by Investment Planning Counsel, a fully integrated Wealth Management Company. Mortgage services provided by IPC Save Inc. Mutual Funds available through IPC Investment Corporation and IPC Securities Corporation. Securities available through IPC Securities Corporation, a member of CIPF. Insurance products available through IPC Estate Services Inc.