Investors act emotionally, not logically, toward the securities they buy or sell.

This dramatically lowers their returns.

But this also means smart investors will start regarding emotion as something they can base investment decisions on. In effect, they can treat widespread emotion as an asset class.

Here's what we mean.

Each year, for instance, Dalbar publishes the "Quantitative Analysis of Investor Behavior".

The QAIB report chronicles the real returns of investors taking into account the actual inflow and outflow from mutual funds using data from the Investment Company Institute.

Year after year the report shows how poorly real life investors do when compared to the broad indexes.

QAIB 2010 was especially critical of Modern Portfolio Theory stating:

"Investors expect to be rewarded for the level of risk they are taking in a particular market." Investment results in 2008 showed clearly that correlation of asset classes varied unpredictably and with no warning. This brings into question the very basis of Modern Portfolio Theory and its ability to forecast an efficient frontier.

This indicates clearly that investors act emotionally, not logically, dramatically lowering their returns.

The report shows that in most time periods, real returns for investors do not beat inflation. In fact, the 2011 edition found that 10-year investor returns beat inflation by a small amount for the first time in QAIB history.

This behavior is reflected in the average mutual fund retention rate. The average holding time or retention period for an equity mutual fund was 3.27 years.

An interesting fact is the mutual fund retention rate was lower in 1999 than in 2008. This means investors were chasing performance faster than they were throwing in the towel in 2008. Big gains stir strong emotions just as much, or maybe more, than big losses.

In truth, this behavior gets to the best of advisors and money managers as well, not just everyday investors.

The National Association of Active Investment Managers, to this point, recently published a survey of active manager sentiment.

The sentiment indicator hit a new low on the same day as the markets hit their low for the year on October 5, 2011. The highest reading was in January of 2007 after four years of positive returns for the stock market indexes. Readings near record highs were also recorded in April of 2011, near market highs for the year. Advisors and managers fell into the same emotional trap as investors.

Richard Ferri states in his book All About Asset Allocation:

"Researchers have uncovered a surprisingly large amount of evidence showing that irrational behavior and repeated errors in judgment explain a significant portion of this known shortfall in individual investment performance. These human flaws are consistent, predictable, and widespread."

These emotional-based mistakes that investors, including advisors, make can be broken into three categories:

1)Overreactions to news or events by selling high quality assets and then correcting their original reactions creating short term "negative bubbles."

2)"Herd behavior." Buying stocks and other assets after their prices have increased substantially because they feel the need "to get in on the action."

3)Irrational, fear-based selling of assets when virtually all investors "run for the exits."

Because these mistakes are "consistent, predictable, and widespread" they can be modeled. Investing strategies can be developed to allow advisors and their clients to profit from the human nature of the market as a whole.

The first chart shows the results of one such investing model, treating emotion as an asset class. This particular model starts putting money into S&P 500 stocks after investors overreact to recent news on a particular stock.

The second chart shows a specific trade suggested by this model. In the two weeks prior to Christmas 2011, Oracle sold off more than 18% on news that their sales were down. They missed their earnings projections on Dec 22. The following week on Dec. 27, the model signaled a buy for Oracle which is now up over 14%.

These types of models tend to have much lower correlation to the overall market than most asset classes. For instance, this model is only 55% correlated to the S&P 500 index while the commonly used emerging market index is 87% correlated to the U.S. market.

The bottom line: Use emotion as an asset class.

Act on fundamental human behavior. And, if your fund follows through, its holdings will be more diversified. And performance greater.

Rob Davenport is president of The Connors Group, a developer of quantified financial market research. Lee Hull is a content team member at The Connors Group, which is based in Jersey City, N.J.

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