MARVIN STEINBERG was a psychologist who founded the Connecticut Council on Problem Gambling. During his career, he made some uncomfortable observations about the behavior of stock market investors. In many cases, he felt, investors’ behavior veered awfully close to gambling.
This is the sort of observation that seems like it could be true, but it also seems difficult to quantify. That’s why a recent study by Morningstar analyst Jeffrey Ptak caught my eye.
Ptak wanted to examine investors’ experience with so-called thematic funds. These are funds designed to take advantage of a trend, such as artificial intelligence, green energy or cybersecurity.
In theory, these funds make sense: If there’s an area of the economy that’s growing, it seems like an obvious place to invest. But that’s not what the numbers show.
In his analysis, Ptak conducted two sets of comparisons. First, he looked at investors’ returns in thematic funds compared to the S&P 500. Since the S&P 500 has done exceptionally well in recent years, and thus represents a high bar, Ptak also compared thematic funds to a set of more broadly diversified stock funds.
The findings? During the period studied—the three years ending Nov. 30, 2024—the S&P 500 returned an average 11% a year, while the more diversified stock funds returned 7% on average. The thematic funds, by contrast, lost an average 1% per year over that time period.
That would be bad enough, but then Ptak looked at what’s known as dollar-weighted returns. This is a methodology that seeks to capture investors’ actual returns in an investment. It does this by taking into account not only an investment’s returns but also the timing and magnitude of investors’ purchases and sales of that investment—in other words, their trading decisions. The results were sobering: On a dollar-weighted basis, investors in thematic funds lost 7% a year—far worse than the S&P 500’s gain of 11% or the diversified stock funds’ 7% a year.
To quantify that, if you had started with $10,000 and invested it in the S&P 500 for the full three years, you would have ended with nearly $14,000. If you’d invested in the diversified stock funds, you would have ended with about $12,000. But if you’d invested in the thematic funds, your investment would have dropped to $8,000.
What explains these results? Ptak cites three factors. First is valuation. Fund companies have a knack for timing the rollout of new funds to take advantage of trends that are in the news. The problem, though, is that the stocks of the most popular companies at any given time often end up being overvalued. But they don’t stay overvalued. After a time, stocks that have been driven up to unreasonable levels often fall back down into more reasonable territory.
The result: Thematic funds tend to be rolled out precisely when valuations are at their highest, attracting investors just in time to see the bubbles deflate. In Morningstar’s research, that explains approximately half the underperformance experienced by thematic fund investors.
The other half of the performance gap was explained by investors’ timing decisions. On average, thematic fund investors tended to buy at high prices and sell at low prices. While unfortunate, this makes sense. If the pattern of these funds is to launch when prices are peaking, it’s understandable that investors quickly regret their decisions and head for the exits.
In fairness, Ptak points out, there’s almost always a gap between a fund’s total return over a given period and its dollar-weighted returns. That’s because investors are always buying and selling shares for their own reasons. Sometimes, they’re investing new savings, and sometimes they’re withdrawing funds to meet expenses. But the difference is typically small. In this study, the gap between the funds’ returns and investors’ returns in the diversified stock funds was 0.65%—much less than the six-percentage-point gap experienced by investors in thematic funds.
What about fees? Thematic funds are much more expensive than standard index funds, costing 0.77% on average. By way of comparison, the best index funds these days cost less than 0.05%.
In addition to the most obvious conclusion—to avoid investing in “shiny object” funds like these—what other lessons can we draw?
In 1987, a Harvard psychologist named Paul Andreassen conducted a study that has earned him a place on the Mount Rushmore of investment research. He created a simulated trading environment and gave participants funds to invest.
Andreassen split participants into two groups: The first received regular news on their investments and were permitted to make trades based on the information they received. The second group were also permitted to trade if they wished, but didn’t receive any news on their investments.
The counterintuitive finding: Those who received no information on their investments ended up making better trading decisions than those who were better informed. More information, it turns out, causes investors to place trades more frequently, and these trades end up being counterproductive. Why? Successful stock trading requires investors to be right twice: First, they need to make the correct investment choice, and then they also need to time their trades correctly. In other words, an investor can buy the right stock but at the wrong time.
Andreassen’s research, I think, helps to explain Morningstar’s findings on thematic funds. To make money in the market, it seems like the right thing is to be informed and to make decisions in line with current trends. But for the reasons Ptak identifies, this turns out not to work. In fact, it’s one of the more effective ways to lose money.
What’s a better way to make investment decisions? The research is clear: As intuition would suggest, and the data confirm, the most important decision is the split between stocks and bonds in a portfolio. While “hot” stocks get all the attention, our best bet, on average, is to avoid what’s in the news and instead to focus on the seemingly more mundane asset allocation decision.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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Guilty as charged… UGH!
To steal a quote from John Mauldin I read this morning, “How many times have we invested in a company or fund solely on the basis of the story we were given by the broker or manager?”
Investing seems to be that rare endeavor which benefits more from less effort, paying less, and knowing less.
The obvious thing to do is to buy the stocks of the best companies in sectors nobody wants right now. And wait, and wait……
That may be the most obvious, but certainly not the easiest, and not the least prone to error. That would be buying the total market – and not have to research which sectors are currently unloved, and which are the best companies in those sectors, and then keep watching to see when both those things are changing…
Good article Adam, and thanks for the links. I’m happy I’m not smart enough to get involved with complicated investment strategies.
How often do some folks need to hear this good advice before they start to listen?