MT422 Unit 9 Investor Behavior Essay Example

A 9.21 Percent Fund and a 6.13 Percent Investor: An MT422 Unit 9 Essay on the Cost of Investor Behavior

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Purdue University Global

MT422: Portfolio Management

Unit 9 Investor Behavior Essay

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[Date]

The investor and her cash flows are composite; both returns were computed from the cash-flow table, and the research findings cited are from the real studies named.

Two Returns From One Fund

A fund's published return and an investor's return can differ even when the investor holds nothing else. The fund's return is time-weighted: it compounds each year's return without regard to how much money was in the fund, so it measures the manager's results. The investor's return is money-weighted: it depends on when and how much she put in and took out, so it measures her results. The two are the same only if she made a single deposit and never touched it.

The Cash-Flow Table

Renata, a composite investor, opened her account with $10,000. The fund returned 18 percent in year one, bringing the balance to $11,800, and pleased with the result she added $12,000, for $23,800. Year two returned 24 percent, bringing the balance to $29,512, and she added $18,000, her largest deposit, for $47,512. Year three lost 21 percent, cutting the balance to $37,534. She withdrew $9,000, leaving $28,534. Year four gained 9 percent, to $31,102, and she added a cautious $3,000, for $34,102. Year five gained 27 percent, to $43,310, and she added $10,000, for $53,310. Year six gained 6 percent, ending at $56,509.

Her net contributions were $44,000: deposits of $53,000 less the $9,000 withdrawal.

Measuring the Gap

The fund's time-weighted return is the geometric mean of its six yearly returns: 1.18 times 1.24 times 0.79 times 1.09 times 1.27 times 1.06, which is about 1.696, raised to the one-sixth power, minus one. That gives 9.21 percent a year.

Renata's money-weighted return is the internal rate of return on her cash flows: the single rate at which the present value of her deposits, less her withdrawal, equals the present value of her ending balance. Solved numerically, it is 6.13 percent a year. The gap is 3.08 percentage points a year, and since she paid the same fees as every other holder, all of it comes from timing.

A simple check confirms the cost. If Renata had spread the same $44,000 evenly over the six years, about $7,333 at the start of each year, she would have ended with $59,887, about $3,400 more, without needing any skill at forecasting.

The fund did its job; the investor's timing took three points a year out of it.

This Pattern Is Not Unusual

Dichev (2007) compared buy-and-hold returns with dollar-weighted returns for whole markets and found that investors' actual returns were lower by about 1.3 percentage points a year on NYSE and AMEX stocks from 1926 to 2002, and by about 5.3 points on Nasdaq stocks from 1973 to 2002, because money tended to flow in after gains and out after losses. Renata's 3.08 points falls between those figures.

Three Biases in the Table

The first is return chasing. Renata's two largest deposits came after the two best years at the start, 18 and 24 percent. Investors tend to extrapolate recent returns, treating a good year as evidence the next will be good too. Her biggest deposit, $18,000, arrived just before the 21 percent loss.

The second is loss aversion, sharpened by watching the account often. Benartzi and Thaler (1995) argued that investors feel losses about twice as strongly as equal gains and that frequent evaluation makes them experience many more losses than long-term holders ever do. After the 21 percent drop, Renata withdrew $9,000, about a quarter of her balance, and then added only $3,000 the following year, so she had less invested for the 9 and 27 percent recovery.

The third is overconfidence in one's own timing. Barber and Odean (2000) followed 66,465 households with accounts at a discount broker between 1991 and 1996; the most active fifth by turnover netted 11.4 percent annually against 17.9 percent for the market over the same years. The more people acted on their own judgment about when to trade, the worse they did. Renata did not trade individual stocks, but each deposit and withdrawal was a judgment about timing, and the table records how those judgments turned out.

Not Every Withdrawal Is a Mistake

The money-weighted return does not distinguish panic from need. If Renata withdrew $9,000 because she lost her job or faced a medical bill, the timing cost was real but the decision may have been sound; she needed cash, and selling at a bad moment was the price of not having a reserve elsewhere. The same table can describe a behavioral error or a liquidity problem, and an honest analysis asks which before assigning blame. In Renata's case, she later said the withdrawal was a reaction to the headlines, which points to behavior rather than need.

Timing losses also differ from cost losses. Fees reduce every holder's return by the same amount; timing affects only investors whose cash flows are badly placed. Both matter, but they call for different remedies.

Remedies Grounded in Evidence

The first remedy is automatic, regular investing. A fixed monthly contribution removes the decision of when to invest, so recent returns cannot influence it. Madrian and Shea (2001) showed how powerfully defaults shape saving: workers enrolled automatically in a retirement plan stayed in it at far higher rates than those who had to choose. The same inertia that keeps people from starting can keep them from stopping during a downturn if the contribution is set once and left alone.

The second is evaluating less often. Benartzi and Thaler (1995) linked frequent evaluation to stronger loss aversion. Checking the balance quarterly or annually, rather than daily, reduces how many losses an investor sees.

The third is a separate cash reserve. If a withdrawal is forced, a reserve means it does not have to come from stocks at a bad time.

The fourth is a written plan that states in advance what the investor will do in a large decline. Deciding before a loss is easier than deciding during one.

What the Gap Shows

The fund earned 9.21 percent; Renata earned 6.13. The difference is measurable, common and largely avoidable, and it arose from decisions that each felt reasonable at the time. The useful lesson is not that investors should be more disciplined but that a few structural choices, automatic contributions, infrequent review and a cash reserve, take the timing decision out of their hands.

References

Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. Journal of Finance, 55(2), 773-806. https://doi.org/10.1111/0022-1082.00226

Benartzi, S., & Thaler, R. H. (1995). Myopic loss aversion and the equity premium puzzle. Quarterly Journal of Economics, 110(1), 73-92. https://doi.org/10.2307/2118511

Dichev, I. D. (2007). What are stock investors' actual historical returns? Evidence from dollar-weighted returns. American Economic Review, 97(1), 386-401. https://doi.org/10.1257/aer.97.1.386

Madrian, B. C., & Shea, D. F. (2001). The power of suggestion: Inertia in 401(k) participation and savings behavior. Quarterly Journal of Economics, 116(4), 1149-1187. https://doi.org/10.1162/003355301753265543