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The Cost of Herding

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Written by: Bill O’Malley | Russell Investments

When children are growing up, the influence of peer pressure is a primary concern for most parents. As my mom used to say – and my wife will no doubt soon echo – “If everyone jumped off the Brooklyn Bridge, would you?”

Children actually aren’t the only ones who risk succumbing to peer pressure. Psychologists have found investors do it all the time. In that case, the behavioral bias is called “herding.” It goes a long way toward explaining why investors tend to prefer investment options that are popular – like 5-star funds, which tend to attract a disproportionate amount of investment dollars.

The rationale is based on our hard-wired perception of safety in numbers. Since “everyone else” is buying the 5-star fund, the typical investor feels comfortable joining the herd, even if that investment option may not be suitable for them personally.

Quantifying the cost of herding

What does this behavioral bias cost the typical investor? A substantial amount, according to a Russell study that compares the return of the Russell 3000® Index and the return earned by the “average” investor1 between 1984 and 2013.

(1) BNY Mellon Analytical Services, Russell 3000® Index annualized return from January 1, 1984 to December 31, 2013.
(2) Russell Investment Group, Strategas & Investment Company Institute (ICI). Return was calculated by deriving the internal rate of return (IRR) based on ICI monthly fund flow data which was compared to the rate of return if invested in the Russell 3000® Index and held without alteration from January 1, 1984 to December 31, 2013. This seeks to illustrate how regularly increasing or decreasing equity exposure based on the current market trends can sacrifice even market like returns.
Indexes and/or benchmarks are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

During that 30-year time period, the Index had an average return of 11% per year. In contrast, the typical investor’s return was only 8.8% on average per year. That average 2.2% difference in returns per year between the Index and the typical investor amounts to a cumulative difference of $103,358 on a $10,000 investment. ($10,000 invested in the Russell 3000® Index during that time period would have grown to $228,923, whereas the average investor’s $10,000 would only have grown to $125,564).

That’s not chump change!

The bottom line

How can you help prevent your clients from engaging in this reckless behavior – especially around the turn of the year, when many investors typically review their portfolios? Emphasize the value of taking a disciplined, long-term approach to investing that is grounded by conviction. Help your client develop a plan that is tailored to their unique situation.

1 Represented by an investor who invested in the Russell 3000® Index between January 1, 1984 and December 31, 2013 using the net flow patterns of actual U.S. equity mutual fund investors tracked by the Investment Company Institute.
The Russell 3000® Index measures the performance of the largest 3000 U.S. companies representing approximately 98% of the investable U.S. equity market.
Indexes are unmanaged and cannot be invested in directly.
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