How to avoid the investor behaviour penalty

Time is running out for investors to take advantage of annual Isa and pension allowances ahead of the tax year end.  

But in the rush to get those last-minute applications filled out, investors should make sure they’re not seduced by a fund that is enjoying a hot streak of form. Those who blindly look at the top performers over a short time period risk going completely against the fundamental principle of investing, which is to buy low and sell high. 

As history shows, those who buy high are likely to be disappointed. In the case of individual equities, a high valuation needs to be backed up by strong growth prospects. The more expensive a share becomes, the harder it is to sustain that level of performance, which is why overheated valuations tend to cool over time.  

When it comes to funds, there’s usually a strong reason why a fund has had a period of short-term strong performance. It could be that the sector or market in which the fund invests has become fashionable, or that the fund manager has made some astute investment decisions that have paid off handsomely.  

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A short-term fund winner could continue to deliver, but the chances are that investors have missed the boat. To make matters worse, investors who buy a top performer tend to cut their losses quickly when performance tails off. This was dubbed ‘the investor behaviour penalty’ by US research firm Dalbar. 

According to Orbis, the fund manager, authoritative studies for the US mutual funds market show that the actual return experienced by fund investors who behave in this manner is about 5 percentage points a year below that of the fund’s published track records. 

There are various ways investors can avoid the investor behaviour penalty, such as taking a long-term view and investing for at least five years. Dan Brocklebank, head of Orbis Investments in the UK, says fund investors can be their own worst enemies by displaying a lack of patience. ‘The biggest challenge, which will help retail investors avoid the investor behaviour penalty, is to stay invested throughout the market cycle,’ he says. 

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There are other ways to avoid falling into the trap of buying the latest trend. One is to look for good-value investments that are yet to shine. These sectors are often contrarian in nature, as the retail investor crowd is selling or showing little interest. 

But, ultimately, maintaining a balanced and well diversified portfolio, will stand investors in better stead, given that it is practically impossible to pick future winners consistently.  

Tom Stevenson, an investment director at Fidelity, notes that those who follow the best- and worst-performing investments year after year will see ‘pure chaos’. ‘In some years, you will see a particular asset class consistently take the top spot. Some years it falls to the bottom of the rankings. Sometimes an investment will have a run of performance lasting several years,’ he says. 

‘The problem is, ahead of time, it’s impossible to know which. The only way to cope with this unpredictability is to be extremely well-diversified and to balance your holdings between investments that behave differently from each other.’ 

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