Investors currently seem scared of everything. Stock market volatility, earnings, Fed policy, energy prices, China’s economy, terrorism, politics, Britain leaving the EU, and inflation are just a few of the many issues keeping investors fearful. This short-term market myopia seems like an opportune time for longer-term investors to take more risk.
Over longer periods of time, returns compensate investors for taking risk. Although everyone is schooled on the concepts of risk and return, investors rarely take advantage of opportunities that might enhance long-term returns because they are too scared to do so. Instead, they cling to past performance believing historical outperformance will continue indefinitely.
Investors tend to be most bullish at the peak of a cycle when they are most confident. Chart 1 shows that investing with such confidence has historically led to significantly inferior returns. The chart compares the 20-year performance of various assets classes to results of the Dalbar study of individual investor returns. Dalbar estimates individual investor returns based on the timing and magnitude of mutual fund flows. Their data suggest that individual investors perform poorly over longer periods of time because they tend to buy when they are most convinced in an investment’s merit and asset prices are elevated, and sell when they are least confident and asset prices are depressed. In other words, individual investors tend to buy high and sell low.
No One Ever Grew Wealth Being Scared
March 7, 2016
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