Most investors are no doubt familiar with the standard industry disclaimer, “Past performance is not indicative of future results.” Yet we know through our research that investors extrapolate recent history into the future when making portfolio decisions. They potentially jeopardize their long-term portfolio returns and financial goals with cognitive and emotional biases.

Many financial advisors can likely relate to the saying, “We don’t have people with investment problems. We have investments with people problems.”
That’s because investors’ emotions and behavior often lead them to inferior performance—they tend to exit stocks and funds before gains (i.e., panicking and selling at the bottom of the market and missing the subsequent upswing) and enter before losses (i.e., investing at or near the peak).

Advisors must ensure that their clients’ risk-taking behaviors are appropriate for their near- and long-term objectives and constraints. In the future, clients will likely put a greater premium on their advisors’ ability to address their emotions and behavior. By educating their clients and helping them maintain perspective and stay focused on long-term objectives—particularly during times of market stress—advisors can help the clients make better decisions and perhaps even see better investment results.

The Problem
The problem is illuminated by data that suggests investments consistently outperform investors. Our firm, Gerstein Fisher, examined the average investor’s actual returns in various asset classes and compared them with the average performance of each asset class over 15 years from January 1, 1996, to December 31, 2010. (We looked at 25,000 mutual funds in Morningstar’s database.) The results were revealing and confirmed our hypothesis that investors’ emotions can be their worst enemy.

They were not simply routinely unlucky—the actual and proximate cause of their lower returns was their trading activity. We found that fully one percentage point of an investor’s annual underperformance relative to their funds could be attributed to that trading. Investors apparently believe that next year’s asset performance will exactly match last year’s. So they chase returns by investing in funds that performed well in the mistaken belief past performance will continue, and replace recent underperformers with recent outperformers. Because they exit before gains and enter before losses, the funds do better than they do.

That problematic strategy shows up repeatedly in our research (as well as in other industry data). We found that peak inflows into bond mutual funds, for example, occurred after equity market corrections (in 2002 and in 2008 and 2009). Similarly, in the late 1990s and early 2000s, approximately $18 billion of new assets flowed into domestic growth equity funds, fueled by investor enthusiasm for the growth-dominated tech landscape. In the three years before their peak level of net inflows, U.S. large-cap growth stocks had annualized returns of more than 14% and had outperformed the global equity markets by almost 4 percentage points a year.

At the same time, investors overweighted their portfolios in growth stocks and underinvested in value stocks, expecting the former to continue beating other assets classes for several more years. But shortly thereafter, the dot-com bubble burst, wiping out trillions of dollars in market value over the following two years.

Morningstar reports that the mutual fund categories with the greatest inflows will, during the three to five years following the categories’ peak inflows, tend to underperform those categories that had experienced the greatest outflows. Consider the pattern of fund flows during and following the late-1990s tech bubble. The peak inflows among Morningstar’s domestic large growth funds occurred in February 2000, right near the market top. The annualized, three-year trailing return for domestic large growth at February 28, 2000, had been 32%. In the year following the peak inflows (from March 1, 2000, to February 28, 2001), the category lost 31.1%.

The Price Of Being Human
Gerstein Fisher has also studied the historical trends of client inquiries and attempts by investors to alter their portfolios, and how these behaviors are affected by market gyrations. We looked at the equity market from 1993 until mid-2010. Perhaps unsurprisingly, the volume of client inquiries was highest right after the sharpest rises and falls in the market (when we excluded the high volume of calls clients usually make just after they open an account). The clients, we found, waited until the period of greatest market volatility had passed, then wanted to do exactly what any advisor would tell them not to do: sell at the bottom or buy at the top of the cycle.

In other words, too often investors depart from a well-designed long-term strategy to pursue short-term approaches that entail excessive trading and higher costs and taxes and that ultimately result in subpar long-term returns. No wonder investment sage Warren Buffett, in a play on Sir Isaac Newton’s laws of motion, has said, “For investors as a whole, returns decrease as motion increases.”

The Role Of The Advisor 
As long as investors are human, these challenges will remain.

We believe that being an effective financial advisor requires a sound grasp of investor psychology. Every day, advisors must recommend investment strategies to emotional investors, keeping them rational when the markets are not.

When perceived risk increases, investors become risk averse and lower their equity allocations, lowering their chances for long-term wealth creation. Although they may objectively understand the relationship between risk and return, they tend to resist the idea in practice. Perhaps the hardest thing for them to do is stay invested when the market is down. When they are confronted with a “fight-or-flight” scenario in a down market, their reflexes come into play. Nobel laureate Daniel Kahneman, writing in the book Thinking, Fast and Slow, says, “Humans are … guided by the immediate emotional impact of gains and losses, not by long-term prospects of wealth.”

Perhaps the best defense against fearful behavior is a disciplined investment strategy based on sound portfolio structure and managed in an equally disciplined manner. Gerstein Fisher endorses the notion that investors typically benefit by having an advisor situated between them and their investments. Advisors can help by educating their clients and helping them maintain perspective and stay focused on the long term, particularly during times of market stress. That means helping them develop a road map for their near-, medium- and long-term objectives and constraints. It also means helping them create wealth protection for times of crisis. That doesn’t mean building the entire portfolio for an unlikely catastrophe, but you should anticipate emergencies—in case the market corrects by 40% or the client loses his or her job, for example—so you won’t need to sell securities in a bear market to meet liquidity needs.
The only way an investor can enjoy the long-term reward for taking the added risk of investing in equities (rather than short-term Treasurys, say) is by staying invested.

(You can find the Gerstein Fisher reports at  http://gersteinfisher.com/gf_article/past-performance-is-indicative-of-future-beliefs/ and at http://gersteinfisher.com/gf_article/preventing-emotional-investing-an-added-value-of-an-investment-advisor/.)

Gregg S. Fisher, CFA, CFP, is chief investment officer of Gerstein Fisher, an independent investment management and advisory firm that he founded in 1993.