Failing the marshmallow test

● Are you aware of the research showing that you typically spend more than you make by chasing top-performing funds?

If you still want to try it anyway, it’s because you are human, says Paul Nixon, the head of technical marketing at Momentum. We find it hard not to do what makes us feel comfortable, he says.

And seeing a fund that performs better than one in which you are invested can make you feel very uncomfortable.

Nixon says investors will switch if the returns on their funds are just 3% lower over a one-year period than those for another fund.

He says we feel like the children in the much-quoted Stanford University psychologist Walter Mischel’s marshmallow experiment.

In the experiments conducted to test the concept of delayed gratification in the late 1960s and early 1970s, children were given a single marshmallow and told if they could wait a short period, like 15 minutes, before eating it, they could have two marshmallows.

Left alone in a room with the marshmallow, many could not wait and ate the single treat before the time was up.

In a paper on South African investor behaviour bias, Nixon and three coauthors say that as investors we must accept we cannot be completely objective. What we should do, though, is “count what counts” when it comes to reaching our investment goals.

First, establish what your investment goal is — for example, the need to achieve inflation plus 5% over every seven-year period (rolling periods). Then measure your chosen investment’s ability to deliver on this goal.

Secondly measure the short-term losses from peak to trough (the drawdowns) over one year and see how severe and frequent these are. Then decide how uncomfortable these would make you and if it could lead you to switch.

Momentum has developed its own outcomes-based investment score to keep tabs on these metrics and investors can use it for any fund on the Momentum platform. The score changes as a fund’s performance changes. Nixon and his coauthors say this sets a personal benchmark for you rather than a market benchmark.

They also say measuring only the investment performance of a fund is like using only the speed of a driver travelling 100km to measure their success. But when driving, the likelihood of a crash or a bumpy journey are also important.