Snails and Buffalos
by Eric D. Nelson, CFA
An article in Sunday’s NY Times reminded me again of the extreme short-term focus and performance orientation of many investors. It told the story of Buffalo Emerging Opportunities (BUFOX), one of the best performing mutual funds in 2013 with a return of +61.7% (the S&P 500 Index returned +32.4%, the small cap Russell 2000 Index returned +38.8%).
BUFOX started 2013 with only $66M in assets, but attracted almost 6X that amount throughout the year to end at $450M under management. Most readers can guess how this story ends, just maybe not how soon it happened. In the first six months of 2014, BUFOX is down -6.7% compared to gains of +7.1% and +3.2% for the S&P 500 and Russell 2000 Indexes, respectively. Of course, the rational thing to do when one component of a portfolio experiences a stretch of underperformance is to add more to it—rebalancing back to its target weight to maintain a consistent portfolio risk/return profile. Investors, predictably, have done just the opposite, withdrawing almost $100M in assets (about 25% of 2013 inflows) in just six months.
This buy high/sell low behavior has a significant impact on investor returns over time. Even including the dismal start to 2014, BUFOX has had good results over the last five years. Its five-year annualized return of +25.9% through June tops both the S&P 500 and Russell 2000 by 7.1% and 5.7% per year respectively. But investors in BUFOX have done far worse. Morningstar reports that the average investor’s “dollar-weighted return” over the last 5 years was only +15.1%, about 10.8% lower than the fund’s return.
In some cases, dollar-weighted returns can be misleading. For example, if a fund has regularly positive inflows from new investors and prudent dollar-cost-averaging, this results in more assets recently than in earlier years and can distort the dollar-weighted return calculation. But that’s clearly not the case with BUFOX, who is on pace to lose 50% of the hot-money assets it took in last year.
Bad investor behavior isn’t endemic only to Buffalo. The St. Louis Federal Reserve recently conducted a study on investor returns vs. reported mutual fund returns and found bad behavior (the same buy high/sell low performance chasing and emotional-based-decision making) cost investors about 2% per year of their returns over the last decade. Morningstar publishes an annual study of investor behavior and found the gap between fund and investor results for the 10 years ending 2013 was about -2.5% per year. Even do-it-yourself investing advocate John Bogle has reported the lag between investor and investment returns to be over 2% per year (The Clash of Cultures, page 113).
So what can be done to stem the enormous investment cost of bad behavior?
First, the design of an investment portfolio should be clearly laid out in an Investment Policy Statement (IPS). This IPS should describe not only the practiced investment philosophy (for example, “asset class investing”) and its central tenants, but also the actual portfolio holdings themselves. The predetermined weights of each holding should be clearly spelled out, as well as the tolerable range of deviation before additional buying or selling is required.
Second, beyond the documented rebalancing process, a minimum “cooling off period” should be imposed before making any overarching portfolio changes. Want to dial up or down the stock/bond split? Outline the proposed changes in an addendum to the IPS and revisit the proposal in a year. If the idea still seems compelling, and the justification still sound, chances are better that it’s based on level-headed analysis and a worthwhile maneuver instead of an emotional-based reaction. In cases where the considered change is more drastic in nature, such as a significant stock/bond adjustment at a market extreme, an entirely new asset class or a brand new strategy with loads of backtesting promise but no real world results, you may instead push the cooling off period back another year or two. Hardly any worthwhile changes to a well-designed, long-term investment portfolio are so important that they cannot be postponed for a year or two.
And finally, try to invest like a snail instead of a buffalo. Instead of buying highly volatile individual stocks, sectors, or fast-moving mutual funds like the Buffalo Emerging Opportunities fund, which holds an extremely concentrated portfolio of 63 stocks in the highly erratic small/microcap growth category, stick with more broad-based and well-diversified asset class and index fund holdings.
At times, these less aggressive holdings might seem to be moving at a snail’s pace compared to hot stocks or mutual funds, but changes are they’ll be easier to hold over the long run. Evidence finds the more volatile an investment, the more likely it is that investors will practice more extreme forms of buy high/sell low behavior. John Bogle, in The Clash of Cultures (page 114), found that the investor/investment lag over a fifteen-year period for the least volatile quintile of stock mutual funds was only -0.8% per year. For the most volatile, it was -3% per year!
Of course, every non-guaranteed investment has risk and volatility, which is why a healthy dose of historical perspective and education can also be crucial to sticking with your investments over time and avoiding the common and significant costs of the behavioral gap. And if this isn’t something you have the time or interest in doing, you’re better off finding a professional advisor to help.