Chasing Performance: One of the Top Investing Mistakes

An article in Sunday’s New York Times about trends in 401k investment choices included this:

Consider those red-hot emerging-markets stock funds, which have soared 28 percent a year, on average, for the last three years. A study last year by Hewitt Associates found that the typical saver who invests in emerging-markets funds in a 401(k) has more than 16 percent of his or her money stuffed into these high-risk investments. Yet many financial planners warn investors against putting more than 5 percent into such funds.

Even worse, nearly one-third of these investors held more than 20 percent of their nest egg in emerging markets — and 5.5 percent were betting more than half on them.

I’m not positive but I think this is even worse that it appears at first glance. Assuming the investor is 65% stocks 35% bonds having 16% of the portfolio in emerging markets would mean 25% of the stock allocation is in emerging markets.

In yesterday’s market selloff the exchange traded fund linked to the MSCI Emerging Markets Index (EEM, see one year chart is at the top of this post) dropped around 8%, double the tumble of the US market:

I would disagree with the maximum 5% allocation to emerging markets, I would put it closer to 10% of the stock allocation of a portfolio based on this sector’s share of the global markets. But of course, during the 3 years of 25% + returns investors should have rebalancing, selling off some of their holdings to get back to their target allocation. The numbers indicate that instead investors were adding to their emerging market holdings.

I have little doubt that in this go round we will see money flows similar to that of last year in this sector. Last year there were major inflows during the first quarter following an excellent 2005. Then followed a massive outflow in response to a 20% selloff in April. Inevitably the market recovered, the asset class had a 20%+ gain for the year, yet many, many investors found that by chasing the market and then panicking they lost money in the sector.

The WSJ marketbeat blog reports :

http://blogs.wsj.com/marketbeat/

The selloff in global equities indeed came at an inopportune time for individual investors. According to data just released by the Investment Company Institute, individuals investing in mutual funds put more money into global equity funds in January than in any month since April, and overall net flows into world equity funds in the last 13 months were nearly ten times the amount into U.S. equity funds.

The ICI said net inflows totaled $21.11 billion in January, after inflows of $149 billion for all of 2006. U.S. funds had a good month as well, with inflows of $7.23 billion, best since March 2006, but inflows into U.S. funds have trailed international funds in every month for the past 13, and in all of 2006 U.S. funds experienced a net inflow of just $11.1 billion.

Doubtless a large % of those flows into international funds was into the emerging market sector.