The scourge of every investor is the so-called "dumb money effect."
It's the idea that when markets are down, investors get scared and yank their cash but when markets are up, investors get too trigger-happy and make bets at the top.
"Investors can counterbalance this tendency by making predictions that place more weight on past results and less on recent outcomes," argues Credit Suisse's Michael Mauboussin.
You can actually see the dumb money effect spelled out in market data.
Mauboussin notes that the annual total shareholder return was 9.3% for the S&P 500 over the past 20 years. The average mutual fund returned 1-1.5% less, due largely to transaction costs.
"But the average return that investors earned was another 1–2 percentage points less than that of the average actively managed fund," writes Mauboussin. "This means that the investor return was roughly 60 – 80% that of the market."
Why would individual investors fare worse than mutual funds? The root of the problem, Mauboussin writes, is "bad timing." It's the dumb money effect at work.
Mauboussin explains how investors can counteract it using the chart below. From Credit Suisse:
This chart shows the correlation coefficient for year-to-year total shareholder returns for the S&P 500 from 1928 to 2013 as well as the MSCI World Index from 1970 to 2013. In both cases, the r is very close to zero. In practical terms, this means that the best prediction of next year's return is something consistent with the base rate. For the S&P 500 from 1928 to 2013, for instance, the base rate is a nominal arithmetic return of 11.3 percent with a standard deviation of about 20 percent.
... And what about 2014? Andrew Garthwaite, Global Equity Strategist at Credit Suisse, forecasts total shareholder returns in the range of 9 percent for the United States equity market and 13 percent for global equities for 2014. The basis for this short-term forecast is that Credit Suisse's strategy team continues to believe that equity valuations remain attractive relative to bonds and that flows into equities have more to go. Naturally, a long-term forecast should appeal to the accumulation of data in the Yearbook. Since 1900, the return for US equities has exceeded that of ex-US equities by 1.9 percentage points per annum. The lesson should be clear. Since year-to-year results for the stock market are very difficult to predict, investors should not be lured by last year's good results any more than they should be repelled by poor outcomes. It is better to focus on long-term averages and avoid being too swayed by recent outcomes. Avoiding the dumb money effect boils down to maintaining consistent exposure.
Here's the chart Mauboussin references above. The correlation between last year's returns and next year's returns are basically zero.
