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Course 408
The Plight of the Fickle Investor

Introduction

In investing, three truths are held to be self-evident:

  • Investors should buy low and sell high.
  • Investors should not be propelled by panic.
  • Investors should not assume past performance guarantees future results.

Or at least that's what everybody says. What fund investors actually do is another matter entirely. They are often fickle, buying funds that have done well (or buying high) and selling in a panic when they stall (that is, selling low). In doing so, investors sabotage their own results. Here's what not to do.

The Tale of CGM Focus

The most recent case of buy high and sell low was CGM Focus. Always volatile, this fast-trading fund grabbed investors' attention in 2007, when it generated an 80% return on the strength of its natural resources bets as well as well-placed short positions in mortgage-related companies such as Countrywide Financial. Predictably, a flood of investor assets whooshed in that year and in early 2008, just in time to see the fund lose half of its value. Through 2008, the fund's 10-year total return was still extremely impressive, at roughly 18% on an annualized basis. But due to poorly timed purchases and sales, the typical investor in the fund actually incurred a 20% loss over that time frame.

History Repeats Itself

Although few funds have cash-flow stories as dramatic as CGM Focus', Morningstar studies have found that investors across all fund types -both stocks and bonds - have paid a price for being fickle.

The damage is greater on the stock-fund side, especially with volatile sector and region-specific funds, in which volatility and temptation are highest. In the natural resources category, for example, Morningstar data show that an investor who bought and held an average-performing fund in the category would have pocketed a very robust annualized total return of 14% in the 10-year period through 2010. But due to poorly timed purchases and sales, actual investors in natural resources funds gained a less impressive 8.7%. Investors in the Latin America and Pacific Asia ex-Japan categories have left even more money on the table due to poor timing decisions. Not surprisingly, both groups have logged periods of exhilarating performance as well as periodic sell-offs. It's easy to get caught up in the excitement of a go-go fund's performance. Don't-don't.

Clearly, emotion has a way of interfering with reason. That's why dollar-cost averaging can be such a good idea. Sure, it's possible to make more money with a lump-sum investment. But it's also possible to make less.

The Lessons

What can fickle mutual-fund investors teach you?

Discipline generally pays.

Because emotions and hype can get in the way of smart investing, systematic dollar-cost averaging--investing smaller sums on a preset schedule--is a sound strategy. Granted, investing a lump sum in the market as soon as you have the cash can be a good approach when the markets just keep going up, or when you are certain you won't give in to the temptation to buy or sell at the wrong time. But in many cases, the dollar-cost average is going to beat the performance chaser.

Don't try to navigate a minefield.

Discipline is particularly important in riskier areas, in which the hope for big gains and the reality of big losses can tempt even well-meaning investors into making trading blunders. If you invest in volatile, aggressive funds such as high-growth, sector-specific, or region-specific offerings, promise yourself you won't back out when returns head south. If the manager and strategy that you originally bought are still there, you should be too.

Don't chase funds.

Of course, even levelheaded, systematic investors need to alter their portfolios from time to time. When moving money or picking new funds, resist the temptation to chase performance. If anything, invest in areas everyone else is ignoring. A regular rebalancing program, whereby you add to holdings that have underperformed and scale back on your biggest winners, can also help you avoid the pitfall of poor timing.

Quiz 408
There is only one correct answer to each question.

1 Fickle investors sabotage their investment returns by:
a. Buying funds when they are hot and selling them when they turn cold.
b. Buying funds when they are cold and selling them when they are hot.
c. Investing a little bit at a time.
2 Which fund types often treat fickle investors the worst?
a. Bond funds.
b. Large-company funds.
c. Sector- and region-specific funds.
3 If you are afraid of becoming a fickle investor, you should:
a. Dollar-cost average into funds.
b. Make lump-sum investments.
c. Try to time the market.
4 If you have new money to invest and you want to invest in an volatile fund, Morningstar would most likely say:
a. Invest it all at once.
b. Invest a little at a time.
c. Wait for the fund to cool, then buy.
5 Which is not one of the three truths of investing?
a. Investors should buy low and sell high.
b. Investors should not be propelled by panic.
c. Investors should assume past performance guarantees future results.
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