What Client Data Teaches Us About Chasing the Market

When it comes to investing for the long term, Wealthfront is an advocate of staying the course and making regular deposits, even when your account is down. In a previous post, we compared the returns of two hypothetical investors, one who invested consistently and one who only invested when her total investment returns since inception were positive. Using simulated returns for Wealthfront portfolios, we found that the investor who disregarded market performance and consistently invested outperformed in the long run.

What Does Actual Client Behavior Show?

Wealthfront has the advantage of having access to actual client behavior and subsequent account performance. In the below analysis, we group clients based on their deposit-timing behavior and compare investment performance of each group.

In order to capture the effect of deposit-timing on account performance, we look at the difference between an account’s annualized money-weighted return (MWR) and time-weighted return (TWR). MWR is the internal rate of return of a portfolio, which includes the impact of deposit timing (controlled by the client) as well as the investment strategy (controlled by the investment manager). TWR, on the other hand, is a measure of the compound rate of growth in a portfolio, which only accounts for impact of investment strategy and is not impacted by when deposits or withdrawals are made. Therefore, the difference between MWR and TWR represents the incremental impact of deposit-timing on account performance.

We sort clients into three groups based on their deposit-timing behavior: contrarian, independent, and momentum. Contrarian investors tend to deposit following market declines, while momentum investors tend to deposit following market increases. The deposit pattern of independent investors is unrelated to the market return. Clients who set up repeating deposits are prime examples of independent investors, as their deposit decision is only related to the passage of time and not market performance.

In order to assign each client to one of these three groups, we run a logistic regression to examine the influence of market performance on a client’s decision to make a deposit. Regression results assign a coefficient to each client, which is a numerical score that represents their susceptibility to making deposits based on market performance. The greater the coefficient, the more likely the investor is to deposit after positive returns, relative to her average deposit frequency. Based on the estimated coefficient, investors are assigned to one of three groups: the bottom third are contrarian investors, the middle third are independent investors, the top third are momentum investors.

Chasing the Market Hurts Returns

The results below summarize the  average difference between the annualized MWR and TWR of accounts in each deposit-timing group over their full tenure as Wealthfront clients (accounts within each group are weighted equally). The results paint a consistent picture. The greater an investor’s tendency to engage in performance chasing, the worse their economic outcome. The MWR of contrarian investors is 27 bps above their TWR, whereas the MWR of momentum investors is 14 bps below their TWR, with both results being statistically distinguishable from zero at the 1% significance level.* By contrast, the differential between the MWR and TWR is statistically indistinguishable from zero for independent investors.

Our Recommendation Remains the Same

We recommend that clients do not let market performance and account returns influence their decision to make deposits. The above results clearly indicate that a momentum strategy has a negative impact on returns. And although a contrarian investor has performed better than an independent investor, the results are partially driven by the fact that all market declines over this time period have reversed, such that “buying the dips” has emerged as a winning strategy.

At Wealthfront, we believe that the financial markets are largely unpredictable in the short run and investors are better off focusing on the long run and investing consistently. A repeating deposit helps clients maintain discipline and stay the course, reaping the benefits of investment automation. While the contrarian strategy seems attractive, it’s important to recognize that executing it requires an ongoing commitment to monitoring financial markets and overcoming behavioral biases to decide when and how much to invest as markets decline. A client who wishes to pursue this strategy would be well served by setting up a recurring deposit, and only then, making additional deposits when markets are down.

*t-statistics for (MWR-TWR) for contrarian investors and momentum investors are 5.80 and -3.25, respectively.

Disclosure

Nothing in this article should be construed as tax advice, a solicitation or offer, or recommendation, to buy or sell any security. This article is not intended as investment advice, and Wealthfront does not represent in any manner that the circumstances described herein will result in any particular outcome. Investment advisory services are only provided to investors who become Wealthfront clients. For more information please visit www.wealthfront.com or see our Full Disclosure.

While the data Wealthfront uses from third parties is believed to be reliable, Wealthfront does not guarantee the accuracy of the information. Past performance does not guarantee future results. The performance information shown includes the reinvestment of dividends and interest.

Commissions are not considered since Clients on the Wealthfront platform are not charged trading commissions.
All Wealthfront taxable and non-taxable accounts and all Wealthfront risk scores as of September 16, 2016 were included in this calculation so long as the accounts had: (1) at least two additional deposits since the accounts’ inception; (2) were active for at least 180 days; and, (3) maintained an average balance of $5,000. Wealthfront compared the account annualized TWR and annualized MWR since inception. To determine whether or not the account deposits followed market appreciation or depreciation, Wealthfront measured the prior monthly market performance of VTI, the Vanguard Total Stock Market ETF which seeks to track the performance of the overall stock market including large-, mid-, and small-cap equity diversified across growth and value styles.