The ‘marshmallow test’ was a series of studies on delayed gratification in the late 1960s and early 1970s. Researchers offered children a choice between getting one sweet they could eat immediately, or getting two sweets for which they would have to wait a few minutes. Many of the kids took the first option. Picture: 123RF/ ANDRIY POPOV
The ‘marshmallow test’ was a series of studies on delayed gratification in the late 1960s and early 1970s. Researchers offered children a choice between getting one sweet they could eat immediately, or getting two sweets for which they would have to wait a few minutes. Many of the kids took the first option. Picture: 123RF/ ANDRIY POPOV

South African investors just can't stop themselves and switch frequently among top-performing funds.

This is despite much evidence locally and internationally that chasing top performers just doesn't work.

And when the cost of this behaviour is measured, the results show that it costs one in four of us as much as 1% a year and one in 10 of us as much as 2.6% a year, says Paul Nixon, the head of technical marketing and behavioural finance at Momentum Investments.

A few investors did marginally better (0.07%) when switching funds during a bull market, but their gains were quickly reversed by switches made after 2014 when the market turned flat.

This 1% a year "behaviour tax" can reduce your investment value by 22% after 10 years, Nixon told advisers at a recent event hosted by the Financial Planning Institute (FPI).

Momentum analysed the investment decisions of almost 80,000 users of its investment platform, which offers the ability to choose from more than 1,500 funds.

It found over the decade between 2008 and 2018 that one in three investors switched funds at some point and 60% of those who switched, switched into a fund with better returns.

But had the 17,900 investors who made on average one-and-a-half switches a year stayed with their original fund choices, they would have been better off by 0.4 percentage points a year, Momentum found.

Nixon says 20% of the time that investors switch on the Momentum platform it is when their returns are good but they are looking for better returns, and 50% of the time it is when their returns are poor and they are looking to rectify that position.

When markets are performing poorly there is more switching, with the average behaviour tax increasing to 1.1% a year,
says Nixon.

Nixon told the FPI event that Momentum also analysed 200,000 switches involving R100bn invested in the four most popular balanced funds on the Momentum platform between 2010 and 2018.

It found "overwhelming" evidence that investors were moving money into funds that had over the past 12 months performed the best out of the four funds, but future performance was often not as good as it was in the past. The four funds performed better or worse relative to each other continuously over the period.

Nixon says Momentum found that, had the investors on its platform who engaged in performance-driven switching chosen a well-diversified fund that matched their ability and tolerance for risk as suggested by their initial fund choices, instead of separate equity, bonds and property funds, they would have been better off, on average, by 0.7 percentage points a year.

Morningstar also recently considered the returns an investor could earn by chasing performance, only to find investors would be better off in a single well-diversified fund.

Victoria Reuvers, director and senior portfolio manager at Morningstar Investment Management SA, said Morningstar created two hypothetical "Performance Chaser" portfolios, one investing in low-equity balanced funds and one investing in
high-equity balanced funds.

In these portfolios investors switched their investments into the best-performing fund from the previous year at the start of each calendar year.

The returns earned on these hypothetical portfolios were compared to two portfolios of unit trust funds managed by Morningstar - one low equity and one high equity.

Reuvers says Morningstar's low-equity portfolio returned in total 6.3% more than the low-equity balanced Performance Chaser portfolio over a period just short of four years to the end of May.

In other words, an investor with an investment of R1m who picked the Morningstar portfolio and remained invested for the entire period would have earned an extra R63,095 in returns.

The difference is even more pronounced in the high-equity portfolio. In this case, the Morningstar Adventurous portfolio returned 13.93% more than the high-equity balanced Performance Chaser portfolio over almost four years, she says.

An investor with an investment of R1m who picked the Morningstar portfolio and remained invested would have earned an extra R139,269 in returns.

Reuvers says this highlights the benefits of staying invested in a robust and consistent strategy as opposed to backtracking and chasing yesterday's winners.

She says a well-diversified portfolio that is designed to meet your investment goals while remaining within your risk tolerance is much more likely to result in long-term investment success than trying to buy yesterday's winners.

Greed and fear are the two extremes that threaten all investment behaviour, says Nic Horn, a director at Citadel.

In an article advising against do-it-yourself investing in a fintech world, Horn says a good adviser can stand between you and your emotions, preventing you from making hasty decisions and keeping you invested in strategies designed to deliver on your shorter- and longer-term investment goals.

Horn says true diversification means investing across different asset classes, sectors and regions, and you should know what is allocated where.


Failing the marshmallow test

Are you aware of the research that shows chasing top performing funds typically costs you more than it enhances returns?

If you still want to try it anyway, it’s because you are human, says Paul Nixon, the head of technical marketing at Momentum, says. We find it hard not to do what makes us feel comfortable, he says.

And seeing a fund performs better than one in which you are invested can make you feel very uncomfortable.

Nixon says investors will switch when returns on their funds are just 3% lower over a ten-year period (2008 - 2018) than that on another fund. 

He says we feel like the children in the much-quoted Stanford University psychologist Walter Mischel’s marshmallow experiment. 

In the ‘marshmallow test’ researchers offered children a choice between getting one sweet they could eat immediately, or getting two sweets if they can wait a few minutes. Many of the kids took the first option. Picture: IGNITER MEDIA
In the ‘marshmallow test’ researchers offered children a choice between getting one sweet they could eat immediately, or getting two sweets if they can wait a few minutes. Many of the kids took the first option. Picture: IGNITER MEDIA

In the experiments conducted to test the concept of delayed gratification in the late 1960s and early 1970s children were given a single marshmallow and told if they could wait a short period like 15 minutes before eating it, they could have two marshmallows. 

Left alone in a room with the marshmallow, many were unable to wait and ate the single treat before the time was up. 

In a paper on South African investor behaviour bias, Nixon and three co-authors say as investors we can’t expect to act without any bias. What we should instead do is “count what counts” when it comes to reaching our investment goals.

First, establish what your investment goal is – for example, the need to achieve inflation plus 5% over every seven-year period (rolling periods). Then measure your chosen investment’s ability to deliver on this goal and if it fails, how far off it is from achieving the goal.

Then measure the short-term losses from peak to trough (the drawdowns) over one year and see how severe and frequent these are. Then decide how uncomfortable these would make you and if it could lead you to switch.

Momentum has developed its own Outcomes-Based Investment Score to keep tabs on these metrics and investors can use it for any fund on the Momentum platform. The score changes as a fund’s performance changes. Nixon and his co-authors say this sets a personal benchmark for you rather than a market benchmark.

They also say that measuring only the investment performance of a fund is like measuring using only the speed of a driver travelling 100kms to measure success. But when driving, the likelihood of a crash or a bumpy journey are also important.    


Chasing winners a losing strategy

There are a number of reasons why switching to yesterday’s winners when fund managers are ranked on returns could lead to your investments underperforming, Morningstar’s Victoria Reuvers says. These include:

  • The selected funds’ good ideas may have all paid off and the returns have been realised;  
  • The funds may have taken an investment stance that paid off and you may have switched at the top of that return cycle – the manager will be taking other stances and waiting for them to pay off;
  • The manager may have been lucky – for example, the fund could have been underweight offshore when the rand strengthened.

When to switch:

Generally, you should not alter your investment strategy or its execution unless it was incorrect at the outset, or your personal or financial circumstances change.

There are times when it makes sense to replace one fund with another, says Paul Hutchinson, sales manager at Investec Asset Management.  These are times when:

  • The portfolio manager(s) and / or the supporting analyst team change and your investment adviser doesn’t think the new team has the old team’s abilities;
  • There is evidence that the manager’s investment philosophy has drifted away from the stated philosophy and the fund will no longer meet your investment objective.
  • The ownership structure of the asset manager changes which can distract the investment professionals. Independent, focused asset managers with significant staff ownership are better placed to deliver on your expectations over time.
  • A better alternative emerges in the peer group.
  • You get better value for money – check out funds that charge lower fees but importantly make sure the net return outcome after fees is better.
  • It turns out your manager had a good luck when you first considered it but now it turns out it doesn’t have demonstrable skill.
  • There are material changes to the economic and investment environment and it makes sense to take less risk by reducing your exposure to funds that benefit from market momentum in favour of those that are more defensive. Timing such a move is extremely difficult, however, and it makes more sense to have exposure to a defensively-managed fund at all times, Hutchinson says. 

Nixon says it is difficult for an investor or adviser to accurately and without bias assess these situations.  He says when there are “changes in economic environment” investors tend to panic switch and make decisions for their emotional comfort. 

For example, they will take money offshore when the rand is weak relative to the dollar – at for example R16 to the dollar it will take on average seven years to break even.

He says these decisions should be left to an investment manager or multi-manager who has rules to make assessments and avoid biases in its due diligence process.