Morningstar Advisor - October/November 2009 - 41

Investor Returns By Alina Tarlea Regret and Risk By Jim Licato Time and time again, financial experts have recommended a long-term approach to investing and have cautioned investors against market-timing attempts. Despite these warnings, a typical trait of investor behavior is overconfidence. People exhibiting this behavior believe they have the ability to identify market highs and lows, and they invest based on this belief. It is extremely difficult, however, to consistently time the market, which is why overconfidence can lead to disappointing results. Contrary to their desired strategy, many investors end up buying high and selling low, which drastically diminishes their returns. Morningstar Investor Returns measure how a typical investor performed over time, incorporating the impact of cash inflows and outflows from purchases and sales, as opposed to total returns, which assume investors held the investment for the entire time period. The graph compares average investor returns for stock and bond funds to the returns of stock and bond benchmarks. For all but two time periods analyzed, investor returns have been consistently lower than market returns. These numbers indicate that many investors keep making investing mistakes and deviating from their investment strategies. Nobody is perfect, and biased investor behavior will not disappear overnight. However, it is paramount for advisors to recognize these biases and educate clients about the importance of –40 a disciplined investment plan. Alina Tarlea is a Morningstar research and communications analyst. Investors often react emotionally after realizing an error in judgment has been made. Investors prone to regret may base investment decisions on regretful decisions they made in the past, encouraging them to become either risk averse or to take greater risks. Consider the situation of each of the following investors. Client A purchased shares in Company ABC on Jan. 1, 2007. He sold the shares at the end of June 2007 because the stock’s performance was flat. Client B considered purchasing shares in Company ABC on the same day Client A sold his shares, but she decided to take a pass. Company ABC went on to triple in price from July 2007 through July 2009. Which investor is unhappier as a result of his or her decision? The outcome is the same; both investors should have the same amount of regret. However, studies show that the regret of having done something is greater than the regret of not having done anything. Therefore, Client A has more regret than Client B. There’s another layer to regret. Daniel Kahneman and Richard Thaler asked 100 wealthy investors to bring to mind the financial decision they regretted most. Most participants reported their greatest regret was from something that they had done. Those who reported a regret of not having done something were shown to take on more risk; they held an unusually high proportion of their portfolio in stocks. In summary, people who regret opportunities they missed take more risks than those who regret attempts that failed. K Stocks Investor returns, equity 0% –10 –20 –30 1 Year 3 Years 5 Years 10 Years S&P 500 TR Bonds Investor returns, ﬁxed income 10% 5 0 –5 1 Year 3 Years 5 Years 10 Years BarCap US Agg Bond TR USD –10 Return data through June 30, 2009. 11111 11111 11111 11111 11111 MorningstarAdvisor.com 41

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Morningstar Advisor - October/November 2009

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