Kym McLeod/Getty Images/iStockphoto
Is conventional wisdom always wise? Not necessarily, in the case of these two investor behaviours – picking mutual funds by using past performance as your guide and dollar-cost averaging, the much-touted strategy in which investors gradually invest small amounts over time in the equity market rather than investing a large lump sum all at once.
Here's some new thinking about these long-time practices.
Buy high and sell low: What happens when you pick mutual funds based on past performance
When you buy a mutual fund or see its promotional material, the fine print reminds you that past performance is not an indicator of future returns. In other words, just because a fund did well last year doesn't mean you should expect the same return this year.
Then why do most investors do the exact opposite?
Here's how typical mutual-fund investors behave, according to Murray Leith, director of investment research at Vancouver-based Odlum Brown Ltd. When an asset class goes up, investors get excited and start buying. When an asset class declines, investors believe there's something fundamentally wrong with it and that the decline will continue.
The result? Investors sell their funds at a low price and buy others at a high price.
"The typical mutual-fund buyer does worse than the market because it's human nature to buy high and sell low," Mr. Leith says.
"Investors pick their investments based upon their beliefs of how things will be in the future based on the experience they had yesterday," says Gregg Fisher, the president of New York-based investment firm Gerstein Fisher.
Take, for instance, Canadian bond funds, an asset class that Mr. Leith says had two strong years back-to-back. In November and December, he says, Canadians put about $3.2-billion into bond funds.
At the same time, Canadians took roughly the same amount out of equity funds.
"It's sort of typical of the crowd's behaviour – jump in after some really great performance," Mr. Leith says.
Mr. Fisher of Gerstein Fisher and Philip Maymin, an assistant professor of finance and risk engineering at NYU-Polytechnic Institute, released a study last year called "Past Performance is Indicative of Future Beliefs" that looked at that investor behaviour and the double whammy it causes.
The study found that when mutual-fund investors chase returns by allocating more money to the funds that performed well – believing that past performance will repeat – the price of those funds rise.
The mathematical model the authors created shows that kind of behaviour ultimately lowers the future returns of high performers and raises the future returns of poor performers.
The study's conclusion: When investors chase returns, they can "create the conditions of their own demise."
Dollar-cost averaging: It may make you feel good, but does it work?
To hear Moshe Milevsky tell it, dollar-cost averaging is a feel-good strategy – which is why it is so popular.
"Psychologically it has a huge appeal," says the professor of finance at York University and author of a slew of books on personal finance and investing. "No matter what happens tomorrow, you can convince yourself that what you did today was the right move."
Dollar-cost averaging is when you have a sum of money and instead of investing it all at once, you deliberately choose to invest smaller chunks over time. (It is not, he says, when you regularly invest in an RRSP or TFSA when you have the money.)
The rationale is that you don't risk putting all your money in the market, just to see it drop immediately. And if markets are declining, the strategy allows you to buy more units for your money, lowering the average cost of your investment.
"So, for example, if you dollar-cost average and you put a little bit in today and a little bit in tomorrow, and a little bit in the next day, if markets decline between now and tomorrow, or between now and next month, you can look back and say, 'Oh luckily I didn't put all my money in because now I can buy it at an even cheaper price,'" Prof. Milevsky says.
"The flip side, if the market goes up, and you have to buy tomorrow at a more expensive price, you can turn this around and say, 'Well, at least I bought some yesterday.' "
Unfortunately, Prof. Milevsky says, his own research and a growing number of academic studies show that dollar-cost averaging only increases the volatility in your portfolio and reduces returns.
Gerstein Fisher, the New York investment firm, did its own study on the benefits and drawbacks of dollar-cost averaging. It looked at two million-dollar portfolios invested in the S&P 500 index between Jan. 1, 1926 and Dec. 31, 2010 – one invested lump sum, the other in 12 instalments at the beginning of each month. The study assumed no transaction costs (which would benefit dollar-cost averaging because of the higher costs with multiple transactions), and compared strategies at the end of the 12th month for each 12-month period.
Over the 84-year period, lump-sum portfolios outperformed dollar-cost averaging 71 per cent of the time with average annualized outperformance of nearly two percentage points over a period of 20 years.
Mr. Fisher says despite evidence to the contrary, dollar-cost averaging is still popular with investors because they believe it helps them "avoid the risk that they will make a mistake.
"But probably the greatest risk investors have is themselves – not the market."