DALBAR’S Quantitative Analysis of Investor Behavior (QAIB) has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds since 1994. The QAIB study revealed that over the long term, the average asset allocation investor earned significantly less than mutual funds with an asset allocation objective. It is important to provide investors with perspective on the prudence of a long-term approach, lessons from past markets and raising awareness of common behavioral influences.
Many investors wait for markets to rise, then pour cash into mutual funds. After markets decline, a selling frenzy begins. Tracking the dollars going into and out of mutual funds against market performance proves the correlation: as markets rise, cash flows swell; as markets decline, cash flows deflate. Unfortunately, this investor behavior erodes returns on even the best-performing fund.
Nothing influences the behavior of investors more than their aversion to loss. The market cycle shown below illustrates investor emotion during periods of expansion, peaks, contractions and troughs. It shows how investor emotions build toward a peak as the market goes up, then plummets under the stress of prospective losses. These emotions, not logic, drive investor decisions. During market swings, investors place too much credence in recent market opinions and events, mistakenly extrapolating trends that run contrary to historical, long-term averages and probabilities. Many wait until the market has already gone up before they buy, then panic when the market drops, selling when prices are low. This pattern—buying high and selling low—shows up consistently in investor behavior over long time periods.
|
Recognizing that all investor decisions are subject to a whole host of behavioral biases and performance of various investments is a function of how they respond to the emotional investment cycle (seen to the right). It’s easy to be right when the market is steadily rising, but during turbulent times, investors need to remain patient.
The proverb patience
is a virtue means that
it is a good quality to
be able to tolerate
something that takes
a long time.
It’s no surprise that many investors are swayed by market and media forecasts. Erratic investor behavior is actually quite common. Investors under perform for a simple reason: they jump in and out at the worst moments. Of course, only with hindsight do we understand that it was the wrong time. And sometimes, market conditions can lure us into thinking that nothing bad can happen. According to DALBAR, “Investor behavior is not simply buying and selling at the wrong time; it is the psychological traps, triggers and misconceptions that cause investors to act irrationally.” |
INVESTOR SENTIMENT DURING MARKET CYCLES 
|
The Six Most Dangerous Behavioral Biases
In recent decades, it has become more widely accepted that psychology and human emotions play a much larger role in economic behavior than was traditionally acknowledged. The principles of behavioral finance help explain why investors often make buy and sell decisions that contradict best investment practices. The top six behavioral biases in which your mind is working against you include:- Loss aversion: expecting high returns with low risk.
- Diversification: Seeking to reduce risk by simply using different sources, giving no thought
to how such sources interact.
- Herding: copying the behavior of others, even in the face of unfavorable outcomes.
- Regret: treating errors of commission more seriously than errors of omission.
- Media response: reacting to news without reasonable examination.
- Optimism: believing that good things happen to “me” and bad things happen to “others.”
The investor needs to commit, for the long term, to a portfolio mix and investment process that gives them a chance to achieve their goals. Working with a financial advisor is another way investors can remove emotions from the process, through a well-defined systematic approach—such as technical analysis, fundamental analysis or dollar cost averaging. Why seek help?
We measured the investors performance vs. the fund’s performance over the last 10 years and highlighted some categories within each market segment. The goal of this review was to understand whether or not individual investors earn the same returns as the funds in which they invest. The net result, investor performance drastically underperforms that of the funds themselves. The results of this analysis reinforces that effects of investor decisions to buy, sell and switch into and out of mutual funds is an issue among equities, fixed Income and alternatives. Many of the categories listed below are actively managed, which raises the question of why investors are timing products managed by skilled portfolio managers?
Ten Year Look: Investor vs. Buy and Hold Returns  Performance displayed represents past
performance, which is no guarantee of future results. Source Morningstar June
30, 2020 |
Over the long term, the financial markets have generally followed an upward trend—with downward volatility along the way. It is during the volatile periods that the investor needs to turn panic into a buying opportunity. Fluctuations in the stock market are to be expected. Investing when prices are low brings the highest returns. A disciplined investment process helps provide protection through even the worst markets. According to the QAIB study, the easiest way to achieve this discipline is with an asset allocation fund.
Retention Rates: Asset Allocation Funds
Source:
Dalbar, 2019. |
The benefits of asset allocation funds, which usually have exposure to a variety of asset classes, comes from their design and construction. Over the past 20 years, mutual fund investors that invested in allocation funds have managed to stay invested almost five years. These investors do, however, stay invested longer than their equity and fixed income investor counterparts. Allocation funds handle portfolio rebalancing for investors, indirectly limiting losses caused by fear-based selling.
Investor Return Difference vs. Buy and Hold Returns
 Performance displayed represents past
performance, which is no guarantee of future results. Source Morningstar June
30, 2020 |
An asset allocation fund can also serve as an investment vehicle for contributions, at regular intervals, in up and down markets. This turns market fluctuations into potential buying opportunities, and, as more shares are bought at lower prices, reduces the effects of market risk. This is an easy concept to state, but it takes patience and discipline to stick with.
Long-term investment results are heavily dependent on investor behavior. Strong mutual fund selection has shown to be typically beneficial. Long-term investors who hold on to their allocation funds have been generally more successful than those who try to time the market. However even minor differences caused from market timing activity can have a dramatic impact on the investors overall results. The table below illustrates the growth of $1 million in a moderate asset allocation (50% to 70% equity category). A buy-and-hold investor who did not time the market generated over $1 million in overall growth and 92.5% in total returns over a 15-year window. 
Performance displayed represents past
performance, which is no guarantee of future results. Source Morningstar June
30, 2020 |
Four Strategies for Dealing with Difficult Markets
When markets are volatile, it’s natural to be worried about the impact on your portfolio. And when investors worry, they are tempted to take action. However, if you have a sound investment plan, it’s important to recognize that sometimes the best course of action may be to do nothing.
It can be painful and upsetting to watch the value of your investments experience a significant drop. There is no strategy that can fully insulate you from a market decline. Just remember markets experienced severe market volatility before, and for investors asset allocation strategies have been proven to add value and help position them to weather the storm and prosper over the long term.
- Take a long-term view- One defense against market volatility is to try to put the daily news into a long-term perspective. Despite the crisis reporting, we know that recessions end, that businesses continue to operate, and that economies and markets recover and grow.
- Be diversified- Diversification is a key principle in investing. It refers to the practice of spreading your investments among the different asset classes: stocks, bonds, alternatives and cash.
- Resist the temptation of market timing- Most investors don’t have the discipline or skill to exit and re-enter the markets properly.
- Take advantage of market volatility- Market declines are the perfect time to act. They become great buying opportunities when many investors are fearful.
- Seek disciplined investment strategies
Disciplined Investment Process
Nobody knows when the next correction is coming, but rest assured, it will arrive at precisely the wrong moment. Investors can protect themselves from the treacherous trap of buying high and selling low by diversifying their portfolios, which can help them avoid making mistakes with their money.
Arrow’s relative strength approach to asset allocation provides broad diversification across sector, style, international, fixed income, and alternative asset classes. Our tactical approach reallocates portfolio segments based on market trends to stay responsive to market conditions. These strategies have a strict buy and sell discipline which removes emotion from the investment process. The systematic process is executed with quantitative analysis. The strategies are intended for patient investors seeking an investment vehicle for contributions at regular intervals, in both up and down markets. It does not make sense to time tactical or managed futures strategies when they are dynamically trading on market trends for the investor. If you’ve experienced subpar performance in the past, take a moment to see what Arrow's tactical and alternative solutions can do for your portfolio.
|
Notes:
1The
2019 QAIB study was performed and obtained from an independent third party,
DALBAR, Inc. DALBAR is not associated with Arrow Funds. The information herein
is believed to be reliable, but accuracy and completeness cannot be guaranteed.
Past
performance does not guarantee future results. Categories display the
returns of current funds in the Morningstar category during the time period
shown, subject to survivorship and/or re-categorization. Index and strategy
research returns assume reinvestment of dividends, but do not reflect any management
fees, transaction costs or expenses. Indexes are unmanaged and are not
available for direct investment. Fund / Buy and Hold (Total Return)
Total return is determined each month by taking the change in monthly net asset
value, reinvesting all income and capital-gains distributions during that
month, and dividing by the starting NAV. Investor (Investor Return)
measures how the average investor fared in a fund over a period of time.
Investor return incorporates the impact of cash inflows and outflows from purchases
and sales and the growth in fund assets. In contrast to total returns,
investor returns account for all cash flows into and out of the fund to measure
how the average investor performed over time.
Historical
information is provided for comparative purposes only. Any forecasts or
forward-looking statements may or may not occur. This material is intended to
be general in nature for informational purposes only. This material is not to
be considered investment advice and is not a recommendation, offer or
solicitation to buy or sell any securities. Investment objectives, time
horizons and risk tolerances vary, and therefore, this material was not
prepared for any individual. The opinions expressed are those of the author(s)
as of the time the material was prepared and are subject to change with time as
market conditions vary. The information, graphs and data contained herein are
derived from proprietary and nonproprietary sources, and have not necessarily
been audited for accuracy, despite being believed to be fair and accurate. As
such, no guarantee nor responsibility is given in any way for errors and/or
omissions. All investments involve risks, including the potential for loss.
Before investing, please read
the prospectus and shareholder reports to learn about the investment strategy
and potential risks. Investing involves risks, including the potential for loss
of principal. An investor should consider the fund’s investment objective,
charges, expenses and risks carefully before investing. This and other
information about the fund is contained in the fund’s prospectus, which can be
obtained by calling 1-877-277-6933. Content reviewed by an affiliate,
Archer Distributors, LLC.
|
|
|
