Investors Miss the Boat Again

Investing is a game in which the spoils go to the quick -- those who are willing to wade in when others are afraid and those who risk their money before a sure thing becomes a sure thing. Unfortunately, the vast majority of investors are pretty risk-averse. They don't like to take chances any more than they have to, and they typically only dive in after the all-clear signal has been given. And even though this behavior can work against them more often than not, it looks like investors are back to their old tricks once again.

Late to the party
According to Morningstar data, investors are finally dipping their toes back into the stock market -- almost a year after the rally took off! After four consecutive months of outflows, investors put $2.7 billion into domestic stock funds and $8.1 billion into international stock funds in the month of January. Likewise, Vanguard Group reported that January was the first month since January 2009 that its stock funds have seen more in the way of inflows than its bond funds -- $7.4 million versus $4.6 billion for bond funds.

But isn't it a good thing that investors are getting reacquainted with the stock market and shaking off their fear? Well, yes, but unfortunately, these investors have already missed the biggest part of the rebound. History has pretty consistently shown that after a recession, the biggest bounce occurs in the months right after the market bottom. Of course, people are typically heading for the exits then, so they tend to miss a lot of that appreciation. Investors also tend to pile into hot asset classes instead of looking for more underappreciated corners of the market. All of this means that we're working against our own best interest by chasing performance.

Behind the numbers
One useful indicator of how investors hurt themselves by engaging in performance-chasing is found in mutual fund investor returns. Instead of looking at what a fund returned over a certain time period (time-weighted returns), investor returns measure how individual investors fared, accounting for the impact of cash inflows and outflows from fund purchases and sales.

Consider the case of emerging markets. This sector posted out-of-sight returns in 2009, fueled by strong performance from stocks like Brazil-based energy firm Petroleo Brasileiro (NYSE: PBR  ) and mining concern Vale (NYSE: VALE  ) . But look at how an investor in Fidelity Emerging Markets (FEMKX) actually fared based on when he bought and sold, versus how the fund itself performed:

Fund 3-Year Annualized Return

(1.66%)

 

Fund 5-Year Annualized Return

12.32%

Investor 3-Year Annualized Return

(6.35%)

 

Investor 5-Year Annualized Return

2.93%

Difference in Percentage Points

4.69

 

Difference in Percentage Points

9.39

Source: Morningstar Principia. Performance through Jan. 31, 2010.

That means over the past five years, investors earned a measly 2.9% annualized return, even thought the fund posted a 12.3% gain. Because folks were buying and selling at exactly the wrong times, they lost out on more than 9 percentage points of additional gain!

Emerging markets provide a good example of how this disparity can develop, since this more volatile asset class has enjoyed some wide swings both up and down in recent years, leading to significant variations in inflows and outflows. This is proof positive that chasing returns and trying to time the market usually ends up costing investors money.

Chasing your tail
So what does all of this mean for an investor today? Well, most importantly, don't make the same mistake by chasing hot performance. For instance, in gold, the SPDR Gold Shares ETF (NYSE: GLD  ) was up 24% last year, while individual gold-related stocks were up even more. Freeport-McMoran Copper & Gold (NYSE: FCX  ) posted an eye-popping 228% gain last year.

With the price of gold having nearly quadrupled in the past 10 years, people are hoping on the bandwagon left and right. But don't expect gold to be the top performer for the next decade. In fact, I think gold has more downside than upside at its current prices. Don't buy gold, or any other asset class, just because it's done well and you don't want to miss the party. Likewise, temper your near-term expectations for emerging markets. I think the long-term growth potential in these regions is excellent, but there are some red flags that may be signaling some short-term volatility on the downside.

Conversely, look to the relatively undervalued corners of the market for opportunities. We all know that emerging markets, metals and mining stocks, and small caps have had their day, but some areas are overdue for their time in the sun. Large-cap growth stocks have been beaten to within an inch of their lives over the past decade, starting with the tech bust that opened the new millennium. Investors looking to capitalize on a rebound in technology spending that will likely accompany our recovering economy should give some thought to companies that are well-positioned to benefit from this trend -- names like Microsoft (Nasdaq: MSFT  ) , Hewlett-Packard (NYSE: HPQ  ) , and IBM (NYSE: IBM  ) .

It's not easy to go against the grain and invest in beaten-up areas of the market, nor is it easy to ignore a red-hot stock or asset class and stick to your guns. However, if investing were easy, everyone would be a millionaire! By sticking to your long-term asset allocation plan, avoiding trends, and not chasing short-term performance, you'll be on the slow boat to riches instead of standing on the pier, watching it sail off into the sunset without you.

For more investing and personal financial-planning tips, check out the Fool's Rule Your Retirement service, which provides top-notch retirement and mutual fund advice. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Petroleo Brasileiro is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft, which is a Motley Fool Inside Value pick. The Fool has a disclosure policy.


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