We still don't talk enough about investor behaviour

It’s taken a long time, but at last investor behaviour is receiving something like the attention it deserves. You might be a genius at picking stocks or timing the market, or know the academic literature inside out, but if you can’t manage your own emotions, you risk failing to achieve all of the goals you set yourself.

Asset managers have a crucial role to play in investor education. But despite the growing interest in behavioural finance, there still aren’t enough people within the fund industry writing about this hugely important subject.

There is, though, a notable exception. Joe Wiggins is a fund manager at Standard Life Aberdeen and the writes an excellent blog called Behavioural Investment. What makes it so readable is its refreshing honesty. There’s none of the usual blah about the benefits of active management; on the contrary, he often writes about its shortcomings, and why investors who choose the active route often end up with disappointing outcomes.

Recently, for example, Joe wrote about what he calls “the paradox at the heart of active management”, which is this. To justify their existence, active managers need to take a contrarian and high-conviction approach. But “the more genuinely active a strategy is the greater the likelihood that it will experience spells of pronounced and often prolonged underperformance, which will be unpalatable for many investors”.

Joe then gives an example of a fund that outperformed the market by an average of more than 4% a year over a 20-year period ending in 2007. By any standards, that’s an extraordinary outcome. The problem is that, across rolling one-year periods, the fund underperformed its benchmark on 34% of occasions. In 17% of the rolling one year periods excess returns trailed the index by more than 10%.
In other words, in order to reap the benefits of the fund’s long-term outperformance, investors would have had to resist the temptation to bail out time and time again.

Simply put, profiting from active investing is extremely difficult. First you have to identify, in advance, a fund that’s going to outperform the market for a very long time, which on its own is no mean feat. But secondly, you also need to stick with that fund when it’s underperforming, when the manager’s investment style is being scrutinised in the media, and when other investors are deserting the fund in their droves.

So, even if you pass the first test and succeed in picking a long-term winner — and only around 1% of funds fall into that category — it will all come to nothing if you fail the second test.

This is a side to active investing that isn’t talked about nearly enough. Fund house marketers and financial journalists naturally tend to focus on the very few “star” managers who have good, long-term track records. So we hear, for example, about Neil Woodford and his record at Invesco Perpetual up until 2014 (or at least we did until the dismal run he’s been on over the last few years). What tends to be glossed over are all those investors who jumped ship at times when Woodford looked anything but a star and his funds seemed dead and buried.

Fidelity Investments conducted a study on its Magellan fund from 1977 to 1990, when Peter Lynch was in charge. His average annual return during that period was 29%, which makes him one of the most successful active managers of the modern era. You would have thought that investors in the fund enjoyed substantial returns, and yet, shockingly, Fidelity found that the average Magellan investor lost money during Lynch’s remarkable winning run. In other words, whenever the fund suffered a setback, money would flow out, and when it got back on track, money would flow back in, by which time investors would have missed the recovery.

Of course, fund management companies are businesses. They make their profits by gathering assets under management. You can understand, then, why they focus so heavily on marketing their funds. But once they’ve got the money in, it’s surely good business to put some effort into keeping it there.

The industry needs to talk much more than it does about investor behaviour. We need more content reminding investors in active funds that they can’t expect a smooth ride, and that sticking with a fund is every bit as important as picking it in the first place. In short, we need more blogs like Joe’s.