It may seem like a reasonable response to move out of investments that are underperforming into those that are outperforming, but this can destroy wealth.

Warren Buffett is widely regarded as one of the world’s most astute investors. As chairman and CEO of Berkshire Hathaway, he has built up a fortune that made him the richest man in the world at one point.

His ability to identify companies that outperform over the long term has made him an icon of the industry. However, he recently gave Yahoo! Finance a powerful example of how simple it can be to be successful.

“I bought my first stock when I was 11 years old,” Buffet said. “It was the first quarter of 1942, shortly after Pearl Harbour. I spent $114.75 … If I put that $114 into the S&P 500 at that time and reinvested the dividends, think of a figure as to what it … would be worth today. The answer is about $400 000.”

That is an incredible investment return in one person’s lifetime, and it could have been gained simply by benefiting from long-term compounding. For that to be realised, however, one had to stay invested.

“Now, the market’s gone down many times during that time,” Buffett pointed out. “People have panicked during that time. Headlines have been terrible.”

There would have been many times when staying in the market would have been extremely uncomfortable. Yet resisting the urge to disinvest would have ultimately led to this extremely positive outcome.

The behaviour gap

It’s a lesson that has a high degree of relevance at the moment. There are any number of reasons why investors might feel uncomfortable right now, particularly given the low returns they have received over the past five years.

However, trying to time the market or pick where it might be best to move your money is rarely more productive than simply staying invested. This is emphasised by a study conducted by an Invest house whose platform we trust and sometimes use –  Momentum Wealth and the North-West University into the cost of investor behaviour.

The research covered approximately 17 600 investors who had money on the Momentum Wealth Platform between January 2008 and January 2018, and investigated what impact switching funds had on their outcomes.

“We had a look at each investor, and what their strategy was when they started the journey, and compared that against what they ended up with after they changed funds,” explains Paul Nixon, head of technical marketing and behavioural finance at Momentum Investments. “We then tracked the two journeys. We looked at original strategy and what return they could have got, and compared that against what they actually got.”

What the study found is that 64% of investors switched funds based on past performance. An annual return from their fund of 3% or more below the previous year tended to trigger a switch to an alternative fund. Doing this, however, resulted in a behavioural cost of 1.38% per annum for some of these investors.

Similarly, a return of 25% on a fund in which they were not invested tended to trigger a switch into that fund. Once again, however, this had negative consequences. It resulted in a behavioural cost of 1.05% for some investors.

Overall, nearly one in four investors incurred a behavioural cost of 1% per annum. That may seem small, but compounded over time it becomes substantial.

During the market crash of 2008, this doubled to one in two investors making a switch. The cost to them also increased to 1.1% per annum.

Avoiding mistakes

For investors, this is a stark lesson. It may seem like a reasonable response to move out of investments that are underperforming into those that are outperforming, but this actually – and demonstrably – destroys wealth.

Advisors also need to take note and be more cognisant of the role they should be playing.

“Your advisor should be the one standing between you and making a poor decision,” Nixon argues.

Many advisors still believe their value proposition is picking funds. It’s not. Their value proposition is articulating your financial goals into something that you can understand and aspire towards.

It is also, critically, a lesson for the investment industry. Asset managers tend to fixate on outperforming their peers, and this narrative is absorbed by investors.

However, as a study by the State Street Centre for Applied Research in 2014 found, this isn’t obviously delivering positive outcomes. While more than 60% of the industry’s capital is spent on the pursuit of alpha (outperformance), only 12% of individual investors could say with confidence that they were reaching their goals.

“The models for success in the investment management industry are broken,” State Street noted at the time. “Investment professionals pay significantly more attention to activities that they believe will contribute value to alpha. While some of these are helpful, many are of limited value. True success includes not only achieving alpha, it also requires helping investors achieve their long-term goals, sustainably, over time.”

This is about a lot more than just performance.

“From an industry perspective, I think companies are going to have to start spending more on showing that they actually understand their clients,” argued Nixon.

“If you are going to charge someone a fee you need to demonstrate value. So if you can start understanding why your investors are making decisions and engage with them more to ensure that they stay on the path and reach their goals, I think that is going to be what the future holds.”