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Mutual Fund Education
Larry Swedroe May 03, 2016
The findings from this study— Do Market Returns Influence Risk Tolerance? Evidence from Panel Data by Rui Yao and Angela Curl—suggest that individuals invest greater amounts after periods when market returns are high and withdraw partially or even completely from the market after periods when returns have been poor.
Today, we’ll examine some additional support for Yao and Curl’s conclusions, as well as explore the relationship between loss aversion and investor overconfidence.
Their study investigated whether the measured risk tolerance of U.S. and Canadian individuals correlated with market movements. Using a dataset provided by FinaMetrica, which creates and distributes a risk tolerance questionnaire widely employed by financial planners, the authors examined average monthly risk tolerance scores (MRTS) during the period from January 2007 through May 2012, a period that spans the financial crisis. A total of 341,782 people were surveyed over the time period. Their objective was to test whether fluctuations in equity returns influence average risk tolerance scores over time. The following is a summary of their findings:
For example, Geoffrey Friesen and Travis Sapp, authors of the 2007 study Mutual Fund Flows and Investor Returns: An Empirical Examination of Fund Investor Timing Ability, found that individual investors lose, on average, 1.56% a year in dollar-weighted returns because they tend to pull money out of equity mutual funds following a significant market decline (when equity valuations are more favorable). Conversely, investors increase equity allocation following recent price increases (when valuations are less favorable).
As yet another example of recency’s impact, one that spanned the period of the financial crisis, the June/July 2011 issue of Morningstar Advisor looked at the behavior gap, the difference between the dollar-weighted returns earned by investors and the time-weighted returns earned by the mutual funds in which they invest, for the one-year and three-year periods ending December 2010. For domestic equity funds, the gap was 2% and 1.3% per year, respectively. For international equity funds, the gap was 0.6% and 0.8% per year, respectively.
To test their hypotheses, they used data from the 2008 FPA-Ameriprise Financial Value of Financial Planning Research Study. The data was collected online by an independent market research firm between June 27, 2008, and July 18, 2008, in the midst of the financial crisis. The total sample size was 2,792 respondents. The survey asked participants for their reaction to the market changes during the past year. One question asked: “Since the market has changed over the past year, what actions, if any, have you taken?” One possible answer was: “Moving assets into more of a cash position.”
Lei and Yao considered it a mistake if investors moved assets into cash in a down market while having an adequate amount in an emergency fund. Because more loss-averse investors are more likely to react in a down market, those who chose these items as answers were considered to be more loss-averse investors. The following is a summary of the authors’ findings, all of which are consistent with findings already discussed:
Clare and Motson examined the impact of timing decisions of both retail and institutional U.K. investors. The authors’ study covered the almost 18-year period from January 1992 through November 2009. The following is a summary of their findings:
The bottom line is that, over the 18-year period, the performance-chasing behavior of U.K. retail investors cost them a total return loss of 20%.
But individual investors aren’t the only ones impacted by these problems. In his book, “Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing,” Hersh Shefrin reported that the risk-tolerance levels of both institutional investors and financial advisors were positively correlated with stock market returns.
Having a sound understanding of risk tolerance is not only important for individual investors, but also for their financial advisors. The research shows that while advisors may treat investor risk tolerance as a stable characteristic, it’s clearly important to periodically revisit their clients’ risk tolerance, as risk tolerance changes not only as investors age but with movement in the markets as well. If an investor’s risk tolerance does change in response to market returns, it’s likely that either the investor (or the advisor) overestimated their ability to understand risk and properly assess their individual risk tolerance. And thus a change in the overall financial plan may be required.
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