The TEXPERS Blog

Bad Investment Habits Can be Detrimental to Your Plan’s Financial Health

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By Christopher McDonough, Guest Contributor

Avoiding bad habits is an important part of life. An unhealthy diet, lack of exercise, and not getting enough sleep can negatively impact your well-being. Similarly, bad investment habits can negatively impact your plan’s investment returns. 

Allowing human emotion to interfere in the investment process

One of the most common pieces of investment advice is “buy low, sell high.” However, when we allow emotion to impact investment decisions, we are more likely to “sell low and buy high”. Markets can experience periods of decline, which can be painful for investors. For example, while the S&P 500 produced a positive return in approximately 75% of calendar years since 1980, the average intra-year decline for the index during this period was -13.9%. Investors that maintain a long-term outlook supported by a robust investment policy are more likely to avoid making emotional decisions and have been rewarded with strong cumulative (+6,512%) and annualized (+11.4%) returns since 1980 despite periods of steep negative returns.

Attempting to time the market

Given the frequency and magnitude of declines in equity markets, investors might be tempted to seek to avoid those declines by shifting portfolio allocations in advance of anticipated negative events. In reality, market timing strategies rarely work, and these strategies can have a significant adverse impact on an investor’s portfolio. Over the last 20 years, the S&P 500 has produced an annualized return of 5.6%. If an investor missed just the ten best days over the last 20 years (just 0.2% of all trading days), most of the positive performance would have been eliminated. Missing the 20 best days would have resulted in a negative return. Investors are better served by remaining invested with a diversified asset allocation designed to meet their objectives over the long term.

Failing to rebalance

As market returns fluctuate, portfolio allocations are likely to deviate from approved target allocations. These deviations can become significant over time and, if not proactively addressed, can be a drag on portfolio returns. A simple portfolio with a beginning allocation of 70% public equities and 30% fixed income would have produced an annualized return of 5.3% over the last 20 years if it were not rebalanced. However, if the portfolio had been rebalanced back to target when the allocations deviated by more than 5% from the target allocation, the return would have increased to 7.4% over the same period. A robust rebalancing strategy allows investors to take advantage of market volatility and removes emotion from the decision-making process. It also forces investors to “buy low and sell high.” 

Churning investment managers

Most plan sponsors would gladly hire an investment manager if they knew that manager would be a top quartile performer over the next ten years. However, it is common for all investment managers to experience periods of underperformance, even if their long-term track record is strong. For example, 74% of the large cap equity managers in the top quartile for 10-year returns have had at least 1 year in the bottom quartile. For U.S. small cap managers, it increases to 89%. A plan sponsor who terminates a manager after a relatively short period of poor performance is unlikely to reap the benefits of their long-term strong performance. In addition, transitioning from one manager to another can cost as much as 1% of assets due to trading costs. When evaluating investment managers, it is important to analyze their performance over multiple timeframes with a particular focus on long-term performance. 

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of Investment Performance Services, LLC or TEXPERS. 

Christopher McDonough

About the Author:

Christopher McDonough is chief investment officer and a senior consultant at Investment Performance Services, LLC. He is responsible for developing and implementing investment policy for the firm. In addition, he works on all aspects of client funds including investment policy formulation, asset allocation strategies, performance monitoring, and manager searches. He serves as chairman of the IPS Investment Committee and a frequent speaker at educational conference. McDonough's manager research responsibilities include multi-asset allocation strategies and private equity.