Investors routinely underperform the indices on which they trade because they do the exact opposite of what we all know is correct – they buy high and sell low. As easy as it is to point out the mistake, it’s much harder to find a solution that investors will stick to. Michael J. Mauboussin, Head of Global Financial Strategies for Credit Suisse Investment Banking argues that investors need a process that takes them out of the rough and tumble of the market and keeps their biases in check.

How the interpreter gets investors into trouble

“There is a part of your brain, in the left hemisphere, that neuroscientists have dubbed ‘the interpreter.’ The apparent role of the interpreter is to assign a cause to every effect it sees,” he writes. “Spurred on by the interpreter, investors tend to extrapolate recent results. This pattern of investor behavior is so consistent that academics have a name for it: the ‘dumb money effect’.”

This effect results in a consistent, and somewhat disheartening, spread between an index, managed funds that trade on the index, and individual investors. The S&P 500, for example, has averaged 9.3% annual shareholder returns over the last 20 years. The returns for actively managed funds are slightly lower, 1% – 1.5%, because of management fees – so far so good. What’s striking is that the individual investors who put money into those managed funds have returns another 1% – 2% below that.

“At first glance, it does not make sense that investors who own actively managed funds could earn returns lower than the funds themselves. The root of the problem is bad timing,” writes Mauboussin.

You only have to look back a couple of weeks to see this effect in action. The S&P 500 had a fairly large correction, and US equity funds had the largest outflows in two years. Investors lost money and reacted by selling equities when they were cheap. No doubt those same investors will reinvest as soon as the price goes up.

equity fund flows and mrkt results 0214 Dumb Money Effect

buy and hold less asset weight 0214 Dumb Money Effect

Dumb Money Effect: Base rates versus specific information

To make a good prediction, Mauboussin explains that investors need to have a clear understanding of base rates, the specific situation they’re in, and which one is more important. He gives the example of the cash flow return on investment (CFROI) for consumer staples and the correlation between a father and son’s height. CFROI in the consumer staples sector is pretty regular, while there is some regression to the mean there is a very strong correlation between CFROI this year and the next. On the other hand, while there is some correlation between a father’s height and his son’s, it isn’t nearly as strong and if you had to make a wager you would want to consider the base case (average male height, in this example).

correlation examples Dumb Money Effect

While most investors assume that specific information is more important than base rates for returns from major indices, this is almost completely wrong. The correlation between returns last year have very little to do with what’s happening now, while the base rate (average returns over time) holds for fairly long periods, which is why making long term investments with a well-managed fund is a better strategy than trying to time the market.

yoy index correlations 0214 Dumb Money Effect