As an industry we are fixated with the returns that our unit trusts managers deliver. But how much of the gains made by unit trusts actually end up in investors' pockets? A lot less than you may expect.
This is true across regions and time periods. A comprehensive study done by the University of Michigan concluded that dollar-weighted returns (the experience of the client) was consistently lower than the time-weighted returns (actual performance of the fund) over a range of markets and periods.
Over an 80-year period in the US, investors received 1.3 percent less per annum because they went in and out of funds at the wrong time. The experience with higher risk markets (such as the Nasdaq) is significantly worse, at 5.3 percent per annum. The study also shows that as the investor holding period has reduced over time, so the deficit has increased.
So where is the performance lost, what are the reasons for the loss and what can you do to avoid a similar fate? These are critical questions. For many investors this could mean the difference between retiring comfortably and struggling to make ends meet.
At first glance, many would think the reason was excessive fees, strange performance reporting or some other shenanigans of investment companies. While this may play a role, a large part of the answer lies in the enormous influence that emotion has on how we invest (the timing of when we buy and sell). The stock market can, and does, easily bring out the worst in people.
There are three main reasons that drive the shortfall, and they are all based on our behaviour:
- Fear and envy;
- The agency effect.
The impact that fear has on investors is well documented and easy to understand. No-one likes the helpless feeling of one's investment declining rapidly — it is easy to panic, to sell and to move to a less risky strategy.
But how is it that some investors, having achieved splendid returns, are pre-occupied with envy because their neighbour did better (Charlie Munger remarked at this year's Berkshire Hathaway AGM in Omaha that envy is the most stupid of the seven deadly sins as you derive no pleasure from it, unlike lust or gluttony).
Countering the emotions
How does one counter these destructive emotions?
The key is to be aware of the damage they cause (education) and to develop a sensible framework with realistic expectations before investing. It is an unfortunate reality that returns in excess of cash go hand in hand with the risk of losing money.
Most investors would be better off investing in appropriate assets, forgetting about it and only re-visiting their position in ten or twenty years. The longer one's time horizon (most people tend to under-estimate their time horizons), the less the short-term gyrations of the market are of concern.
Article continues on page two and three: noise, the agency effect and the answer to this difficult dilemma...