Irrational Investor Behavior Results in Portfolio Underperformance

Baron Capital Management’s Chairman, President and COO, Linda Martinson, warned attendees at her company’s recent annual investment conference in New York to beware of market bubbles and the dangers of investor’s irrational behavior.

Martinson started by saying that investor irrational behavior can be very costly. She referenced a study by Dalbar, a financial services market research firm, which concluded that “Irrational behavior is the primary cause of investor underperformance over the last 20 years.”

Some of the irrational investor behavior includes panic selling and excessively exuberant buying. The study estimates that over the 20-year period, irrational investor behavior resulted in equity losses of $122 billion.

“Investing seems simple. You buy low and sell high,” continued Martinson. It should be fairly simple to establish financial goals, determine the best steps to achieve those goals and then follow the steps. However, most investors lack patience and discipline to follow the steps precisely. Eventually, most investors succumb to emotional behavior.

Irrational behavior does not depend on an individual investor’s intelligence, education or knowledge of financial markets. The main reasons for an investor’s irrational behavior are usually greed and envy. To illustrate this point, Martinson told the story about Isaac Newton investing in the South Sea Company stock.

The short version of the story is that Newton bought some shares and then sold his shares for a substantial return after the share price increased a few months later. However, South Sea Company’s share price continued to rise.

Afraid that his friends are making money and he is missing the opportunity, Newton reinvested most of his assets at more than triple the price at which he sold his shares just a few months earlier. Not long after Newton reinvested, the bubble collapsed and Newton lost almost all his life savings – equaling about $4 million in today’s money.

When asked to comment about his South Sea Company investing experience, Newton allegedly stated, “I can calculate the movement of the stars, but not the madness of men.”

Personal biases cause most of our irrational behavior, Martinson explained. She mentioned confirmation bias, recency bias, familiarity bias, gambler’s fallacy, regret aversion and herd behavior as some of the most common biases. Regardless of the type of bias, the resulting emotional investing decisions usually lead to poor financial performance.

Martinson presented a chart that compared equity mutual fund flows with the return on the S&P 500 a year later. The chart indicated that stock fund inflows were highest right before a market crash and that fund outflows were highest just before a market recovery.

Data indicates that $170 billion left the market between August 2011 and December 2012, thus, missing out on returns of up to 30% over the following 12 months. Irrational behavior differentiates high rates of return from mediocre performance or loss over a long period.

Quoting investor Benjamin Graham, Martinson said that “People don’t need extraordinary insight or intelligence. What they need most is the character to adopt simple rules and stick to them.”

The keys to achieving excellence in anything are discipline and patience, Graham said.

Martinson also displayed a chart that illustrated the relationship between market levels and investors’ feelings about the market. Investor optimism increases as the stock market rises. Optimism turns to euphoria until the market peaks and starts declining. At that point, investor euphoria turns to anxiety. As the market continues to decline, investors go through a series of emotions — fear, panic and despondency. Once the market starts to recover, investors start feeling hope on the way to optimism and the cycle starts again.

Baron Funds’ managers forecast that the market is currently at a high point and that this is an opportunity for active managers, Martinson reported. Historical data shows that active managers perform better during uptrends and down markets. Actively managed accounts lag behind passive accounts when the markets are high.

The stock market has been in one of the strongest bull markets in history for the last seven and a half years. Consequently, investor’s attention has been on passive funds during that time. Passive investments offer more certainty in the short term. However, Martinson argued that focused active managers tend to generate exceptional returns over the long term.

Martinson concluded by emphasizing that long-term success in investing, like in any other endeavor, requires patience and discipline, because “exceptional takes time.”

Ned Piplovic is the assistant editor of website content at Eagle Financial Publications. He graduated from Columbia University with a Bachelor’s degree in Economics and Philosophy. Prior to joining Eagle, Ned spent 15 years in corporate operations and financial management. Ned writes for www.DividendInvestor.com and www.StockInvestor.com.