When Past Performance is Irrelevant

Sarah F. Roach

There is ample evidence that people can be their own worst enemies when it comes to investing, particularly when their professed financial goals are compromised by emotion-based decisions. For example, data collected by Morningstar has consistently demonstrated that individuals earn lower returns than the mutual funds in which they invest, a situation that is solely the result of investors’ deposit and withdrawal decisions. Take the Schwab Total Stock Market Index Fund for example. Over the past three years, individual investors have averaged returns of 1.12 percentage points less per year than the fund itself. Over time, such underperformance can really add up. Long-term clients will be familiar with some of the causes of this disparity, since we’ve written about this phenomenon before: 1) buying high and/or selling low—typically during times of excessive optimism/ pessimism; 2) overreacting to news, sometimes to the same news repeatedly; and 3) overconfidence in one’s own investment skills. These behaviors, and others, comprise the field of behavioral finance.

Recently, Barron’s reported on yet another study that demonstrates investors’ behavioral quirks. Steffen Meyer of the University of Denmark and Michaela Pagel of the Columbia Business School looked at 10 years of investment transaction history for more than 100,000 German investors. Specifically, they wanted to know what investors did with their cash when a mutual fund they owned was liquidated. Put differently, did people reinvest when an external event precipitated the sale of one of their investments?

The researchers found that 70% of such investors reinvested within a month of the mutual fund liqui­dation; however, there was a significant difference between people who’d realized a gain as a result of the liquidation and those who’d realized a loss. “Winners” reinvested 83% of their money, while “losers” reinvested only 40% of theirs. After confirming that the people comprising each group were not dissimilar in any meaningful way, the researchers concluded that they were witnessing yet another emotion-driven behavior: loss aversion—succinctly defined by Daniel Kahneman and Amos Tversky by the catch phrase “losses loom larger than gains.”

Research conducted in 2014 by Carnegie Mellon professor Alex Imas offers a more granular expla­nation. Imas found that when people have a paper loss (also called an unrealized loss), their reactions are less acute and painful. In contrast, once a loss is realized, as was the case in the mutual fund liqui­dation data, loss aversion kicks in, and investors are more likely to react emotionally.

Since the historical superiority of equity returns compared to most other assets suggests that long-term investors should keep their money invested regardless of short-term results, rational (and emotionless) “homo economicus” would treat the proceeds of a forced sale identically, no matter the investment results that came before. However, plenty of research suggests that “homo emotionalis”—to coin a new label—tends to win the day, often to his own detriment.