A Simple Psychological Mistake Is Costing Investors A Fortune

The average mutual fund investor is missing out on 2 percentage points of annual returns by making one terrible psychological mistake: They're putting more money into funds after periods of strong returns, and then they're yanking their money out of funds when performance is weaker.

YiLi Chien, Senior Economist at the St. Louis Fed, has a short paper up about Return-Chasing Behavior, which is basically what's described above, the tendency of investors to react to the latest moves of the market, rather than hold tight.

This chart shows the phenomenon. As you can see, when quarterly mutual fund returns (orange line) are higher, people put more money into mutual funds (blue line). When returns are lower, investors pull money out.

Investors shouldn't be reacting to the past like this. They should just be holding steady through the market swings.

The study's conclusion:

To assess how much return-chasing behavior costs investors, I compared the actual realized return of return-chasing behavior in our sample to a simple buy-and-hold investment strategy (a strategy in which investors simply buy equity and hold it for an extended period of time). We set the holding period of the buy-and-hold strategy to five years. (The result would be even stronger if the holding period was longer.)

Return-chasing behavior involves the size of investors' equity positions changing over time, so the returns of both investment behaviors were evaluated in terms of so-called asset-weighted return. Note that the asset-weighted return of the buy-and-hold strategy simply equaled the time-weighted return during the holding period, which is the standard definition of average equity return reported on financial statements.

The result shows that return-chasing behavior had a significant impact on the performance of return. The buy-and-hold strategy earned an average annual return of 5.6 percent in the sample period, while return-chasing behavior only realized 3.6 percent. In other words, chasing returns caused the average U.S. mutual fund investor to miss around 2 percent return per year, which is very significant.