Imagine investing in a fund that returned an average of approximately 30 per cent a year for more than a decade. Interested? Sounds like a recipe for a winning portfolio.
Except for some, it wasn’t. Or so the story goes. We don’t know how many investors actually lost money in the fund, but there is a lesson in it for all of us.
In 1977, Fidelity Investments named Peter Lynch as the head of the obscure Magellan Fund. It had only about $20-million in assets. By the time Mr. Lynch resigned in 1990, the fund had grown to $14-billion in assets.
While the returns were certainly impressive, many of the investors in the Magellan Fund lost money, if Mr. Lynch and multiple press accounts are to be believed.
How is that possible? In reality, great fund performance does not necessarily translate into great investor performance. To get those returns, investors have to stay invested long-term and avoid the temptation of trying to time their purchases and exits.
Investors typically “flock” to a new investment if it has reported great numbers the year before, then dump it when there’s “bad news” in the market. Market research studies have shown that the average holding period for equity mutual funds is less than three years. The average holding period for individual stocks is about 5.5 months, according to data from the New York Stock Exchange. To put that in perspective, the average holding period of stocks in the late 1950s was eight years.
According to market data, during any 12-month period in which Mr. Lynch managed the Magellan Fund, it lost money 17 per cent of the time. This is not only possible but reflects market reality. Over the last 43 years, the S&P 500 dropped an average of 14.3 per cent during the year; nevertheless, it rallied to positive annual returns in 32 of these years.
And this leads to a key obstacle that investors need to be aware of: the action bias, or the preference of action over inaction, even if that might not yield a better result.
A study of penalty kicks in soccer shows the impact of the action bias. In soccer, when there is a penalty kick, the player kicks the ball from a stationary point 11 metres from the goal, with only the goalkeeper allowed to defend it. Little surprise that 80 per cent of penalty kicks result in a goal. It takes a fraction of a second for the ball to travel the 11 metres, so the goalie must decide which direction to move with little information.
The research found that the optimal strategy was for the goalkeeper to stay in the goal’s centre. Yet, they only did so about 6 per cent of the time. This is the action bias: It is better to look like you are doing something, even if it is counterproductive, than to stand still.
This same bias plays a role in investor behaviour. A famous study found that people who trade the most – action bias and overconfidence at work – turning over their entire portfolio almost twice in one year, underperformed market returns by about 6.5 per cent annually. Volatile markets tempt investors to check their portfolios more frequently, which could lead to even more detrimental actions such as increased trading. The average investor earns below-average returns because they typically buy high because of FOMO – fear of missing out – and they sell low because they overreact to bad news.
How can investors avoid falling victim to the action bias? Gary Klein, a research psychologist, formalized an approach he called a premortem.
Most companies look at a failed project after the fact and investigate what went wrong. Mr. Klein advocated turning this logic around, similar to the inversion strategy used by Charlie Munger, Warren Buffett’s partner: Imagine it is a year from now and the decision you have taken today has failed miserably. What could have happened? This type of approach forces the decision makers to bring to the surface the threats and hurdles that might otherwise remain hidden. It also works for investors to surface the potential consequences of decisions based on action bias.
What we do can hurt, but so can what we fail to do. The challenge is to know when to act and when to sit still. Luckily, most investment decisions are not life-or-death. We can take time to let the emotions cool and our rational brains kick in.
We can benefit from the wise words of French philosopher Blaise Pascal: “All of humanity’s problems stem from man’s inability to sit quietly in a room alone.”