Investors: Repent & Reform

By: Frank Armstrong, CFP, AIF
Evidence keeps piling up that investors are their own worst enemies.
Of all the risks that investors face, their own behavior may be the biggest. Dalbar, a financial industry research group, established the link between dysfunctional investor behavior and long term significant underperformance in their ground breaking study, “Quantitative Analysis of Investor Behavior” first published in 1994.
Dalbar’s recently updated paper extended the period to include January 1984 to December 2000 but confirmed the central finding: “Investment return is far more dependent on investor behavior than fund performance. Mutual fund investors that practice buy-and-hold strategy earn higher real investor returns than those who attempt to time the market.”
Dalbar tracked cash flows into and out of mutual funds against price levels to deduce investor performance (dollar weighted) as opposed to fund performance. Investors are so inept with their market timing attempts that they consistently grossly under-perform both a simple, naive buy and hold benchmark, and the returns of the funds that they invest in.
The extent of the underperformance is staggering. During the study period, perhaps the best bull market in history, the S&P 500 returned 16.29% per year, while the average domestic equity fund investor earned 5.32%! Folks, that’s less than 1/3 of the market return! What could possibly cause a disaster of this magnitude?
Bond investors faired almost as poorly: 11.83% for the long term government bond index vs. investor performance of 6.08% for mutual fund bond investors.
But, it gets worse! Dalbar’s estimate disregards sales loads and transaction costs. These costs further erode the net returns to the investor. But It gets worse still. With investors turning over their funds every 2.6 years on average, the tax implications are horrendous. Taxable investors got to pay income tax on any earnings over six times during the 17 year period, another serious drag on performance not measured by the study.
Perhaps two percent of the shortfall can be attributed to active management costs of the mutual fund universe. It’s no big news that active funds on average lag the appropriate index by the amount of their costs. But, Dalbar attributes the rest of the performance gap to investor behavior. The short version is that investors simply can’t resist the temptation to load up on funds after performance has peaked. Cash flows into mutual funds increase directly with past performance, market timing at its very worst!
Buy high, sell low and wonder what happened is not an investment strategy calculated to maximize returns. It is a character flaw, a disease, a dysfunctional behavior problem.
If investors did so poorly in the best bull market in history, how will they do when times get tough? If they don’t do better, how will they ever meet even modest financial goals?
Investors need to look closely at themselves, cure their addictions and afflictions, reform and repent. If they can’t straighten out, then they should get professional help. Otherwise, they will wake up someday and wonder why their hopes and dreams never came true.

By | 2018-11-29T16:12:53+00:00 September 28th, 2012|Blog|

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