How retirement investors hurt themselves
Reprinted courtesy of MarketWatch.com.
To read the original article click here.
A Boston research firm named DALBAR just released its 20th annual “Quantitative Analysis of Investor Behavior.”
Should you care? You bet.
In fact, I think every serious investor needs to know what’s in this report. Sure, the title sounds pretty awful, but this will be easier than you probably think.
For the past 30 years, DALBAR has been collecting data on investors’ cumulative decisions about when to buy, sell and exchange mutual funds. The firm has been issuing annual reports on this data since 1994.
Every year the conclusion is the same: On average, investors earn less than mutual fund performance figures imply. Sometimes they earn much less.
Furthermore, DALBAR has concluded this isn’t the fault of the mutual funds but the fault of investors — and in many cases the fault of brokers and advisers who direct mutual fund purchases, sales and exchanges.
The latest report covers 30 calendar years, 1984 through 2013. This includes the sudden market crash of 1987 and three major bear markets of the early 21st century as well as the 1990s bull market and several strong market recoveries.
One conclusion: No matter whether the market is booming or busting, “Investor results are more dependent on investor behavior than on fund performance.” Investors who buy and hang on are consistently more successful than those who move in and out of the markets.
For its data, DALBAR studies mutual fund sales, redemptions and exchanges each month to reflect investor behavior in the aggregate, as if the sum total of all inflows, outflows and exchanges were made by a single investor. That hypothetical investor’s return is regarded as the average return for purposes of this study.
These “average” returns are compared with results of mutual funds themselves and of common indexes for stock and bond funds. This captures the effect of capital gains, dividends, interest, trading costs, fees, expenses and other costs.
Here are some highlights of what was found. Though DALBAR tracks fixed-income funds and asset allocation funds, I’ll focus on investor behavior in stock funds.
In 30 calendar years (1984 through 2013), the Standard & Poor’s 500 Index SPX -0.47% compounded at 11.1%. In that same time, the average mutual fund investor (as defined above) achieved a return of only 3.7%. In other words, actual investors actually earned barely more than a third of what they could have earned.
During the past 20 calendar years, the index was up 9.2%, while the average investor got only 5%. In the past 10 years, the S&P 500 was up 7.4%, and the average investor’s return was 5.9%.
Last year, 2013, was far above average for the U.S. stock market: The S&P gained 32.4%. But in the aggregate, investors couldn’t seem to settle down and accept these gains. The average investor’s return last year was 25.5%, leaving nearly seven full percentage points on the table.
The numbers change from year to year, but every DALBAR report comes to the same conclusion: Investors’ emotion-based trading is counterproductive.
Along with many others, I have tried over the years to educate investors about the effects of what DALBAR describes as “knee-jerk reactions to crises and mistakes.”
Has that helped? Here’s what DALBAR says: Despite “enormous efforts by thousands of industry experts to educate millions of investors, imprudent action continues to be widespread. … The belief that investors will make prudent decisions after education and disclosure has been totally discredited.”
That’s the bad news. But there is very good news here for anybody who’s still paying attention. As an individual, you don’t have to do what everyone else does. You can chart your own course.
The lesson from all the data in this long-term study is crystal clear: If you properly allocate your investments and then hang onto them through thick and thin, you are highly likely to get above-average returns.
This doesn’t mean you’ll “beat the market” or the indexes. But it does mean that your returns will be above the average of all investors.
DALBAR outlines several steps that investors — and those who direct their decisions — can take to reduce the problem:
- Set your expectations below the historical performance of market indexes.
- Control your exposure to risk.
- Monitor your tolerance for risk, because it is likely to evolve over time.
- Make your forecasts in terms of what’s probable instead of what’s possible.
The latest DALBAR report is far too long to do it justice here, but I’d like to point out three findings that caught my attention.
First: Investors lose more of their potential returns after (not during) market declines. Investors tend to sell after they have taken serious losses and don’t return until the markets have recovered.
In other words, to use an oversimplified example, if you start the market decline with $10,000 invested in a fund, you may sell after the value has fallen to $6,000. You buy back in only after the fund has recovered. You now have only $6,000. Had you stayed in the fund, at this point your investment would have been worth $10,000.
The fund has broken even; you have lost $4,000. This happened because you were IN the market while it was falling and OUT of the market while it was rising. Exactly the opposite of what you probably wanted to do.
Second: Even though the evidence for buying and holding is overwhelming, DALBAR concludes, “at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets.” That average investor “generally abandons investments at inopportune times, often in response to bad news.”
Third: Investors in “asset allocation funds,” those that include both stocks and bonds, are somewhat more successful. These investors, in the aggregate, hold on to their shares longer than investors in either stock funds or bond funds.
This is most likely because those investors don’t expect such “balanced” funds to perform as well as equity funds or preserve capital as well as bond funds. These blend funds are less likely to produce the dramatic ups and downs that tempt investors to buy and sell.
(I believe that this same effect can be achieved by portfolios made up of stock funds and bond funds, so long as investors focus on the returns of the whole portfolio, not those of the individual funds. However, that is often much easier to say than to do.)
Even though the lesson from this is simple and well-known, most people struggle to follow it. Why? Probably some combination of emotional responses to events and Wall Street’s pressures to generate income from transactions.
I think the most reliable way to overcome this hurdle is to use an independent investment adviser, one without any financial incentive to persuade you to buy, sell or trade.
Based on all the information I’ve seen over the years, investors who rely on such fiduciary advisers are more likely to be successful in the long run than investors who don’t.
A good adviser can help you get on the right course and help you stick to it. That will greatly improve the probability that you will receive the market’s long-term returns instead of falling far short of them.
That, I believe, is the most valuable thing most investors can learn from the DALBAR report. (For more on this topic, check out my podcast .)
Richard Buck contributed to this article.