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When Investors Are Their Own Worst Enemies

Statistics show buy-and-panic investors don't do well.
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The most important factor affecting a mutual fund investor's return is not necessarily a portfolio manager's style or even the performance of the market at large. It's the investor's own behavior.

Because some investors don't understand risk -- intellectually and emotionally -- they can be their own worst enemies. I've seen evidence of this in the form of skittish investors pulling money out of a mutual fund when it's down. They get scared and run for cover. There are lots of reasons a mutual fund may be down, such as a manager going sour or a fund getting too big. That's not what I am referring to. I'm talking about a mutual fund that goes down simply because the market is down, and the scared investor pulls out.

Bill Miller's


Legg Mason Value Trust is down about 12% since Jan. 1. Has the guy who surpassed

Peter Lynch

by beating the market nine years in a row all of a sudden lost it? An investor who pulls out simply because he or she is scared of a 12% drop shouldn't be in the market, or his fund, in the first place.

Obviously, an investor who pulls out in a panic wouldn't know when to get back in. A day or two of big moves could make a significant difference. A savvy investor would realize Miller is in a compression for a while. He is hurt by his top holdings,

America Online








and from the pure value plays, like

Bank One



Waste Management


. If investors stay on board, they'll probably be fine.

Not to be labeled a hypocrite, you should know that I have reduced positions with Miller's funds and in some cases totally pulled out of them. Not because he's suddenly a lousy manager or because I am scared, but because I saw more opportunity in biotech, health and growth in mid- and small-caps. So much for personal opinion, let's look at some data.


, a Boston-based mutual fund research firm, recently published a study of how investor behavior impacted mutual fund returns from January 1984 through December 1998. Though the study looked at stock and bond funds, I'll limit my discussion of the report to only the stock fund findings.

The study looked at cash flowing in and out of funds to determine how long investors remained in their funds. Its conclusion: "Investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who practice a buy-and-hold strategy earn higher real investor returns than those who attempt to time the market."

The following chart presents the inevitable bottom line of the analysis:

As you can see from the chart, the

S&P 500

index returned an average of 17.9% per year while the typical equity fund investor earned only 7.25% per year over the same period. Dalbar blames the gap on "investors' attempt to time the market, rather than remaining invested for the entire period."

If there is a weakness in the Dalbar study, it lies in the assumption that the investor is trying to time the market. That may not be true for two reasons:

  • There is a big difference between pure market-timing and pulling out because you're just plain afraid of losing money.
  • Some people intentionally withdraw to invest elsewhere more opportunistically. Admittedly, this is a different kind of timing, but the investor is still in the market.

Attributing motives to behavior is always tricky at best, but if you are wrong about the motive, the results are not totally persuasive. To totally validate its findings, Dalbar would have to trace investor names to all cash inflows and outflows. That isn't likely, but probably not necessary to make the main point of the analysis.

The main point is that investors who pull out of a fund when fear takes over probably won't get back in at the right time. As a result, they won't have as good a performance as the fund itself. You only need to go back to Aug. 31, 1998, when the

Dow Jones Industrial Average

dropped 513 points. The next day, the Dow bounced back 288 points. A fearful exit from a fund on Aug. 31 was very costly.

Next time you look up a fund's


rating, be sure to check out your tolerance for its volatility. Then check out your real behavior pattern, not just what you think, but how you'll sleep. Keep the following chart in mind:

Vern Hayden is a certified financial planner in Westport, Conn. He is a financial consultant and advisory associate of Financial Network Investment Corp. He also is an owner of Hayden Financial Group. His column is not a recommendation to buy or sell stocks or to solicit transactions or clients. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks or funds. While he cannot provide investment advice or recommendations, Hayden welcomes your feedback at