Investors are their own worst enemy, or so is the conclusion of Dalbar’s 22nd annual Quantitative Analysis of Investor Behavior study that compared equity fund returns of directed investments versus the market benchmark. This year’s study found that in 2015, investors returns came in at -2.28% for equity funds while the S&P 500 benchmark had incremental gains of 1.38%, thus the average equity investor underperformed the S&P 500 by 3.66 percentage points. The good news is that’s better than 2014, in which investors left 8.19 percentage points on the table.
The bad behavior wasn’t limited to equity funds, Dalbar found. Those selecting asset allocation funds had returns of -3.48% (vs. the 1.38% S&P 500), and fixed income funds had -3.11% returns, versus the Barclays Aggregate Bond Index return at .55%. Bottom line: “Investment results are more dependent on investor behavior than on fund performance," Dalbar concludes. "Mutual fund investors who hold on to their investments have been more successful than those who try to time the market.”
Lou Harvey, Dalbar CEO, says one of the biggest surprises in this year’s study was the large impact expenses, i.e. fees, have on returns. Fund expenses, including management fees, account for almost 23% (vs. bad behavior being 42.6%) of the major causes of equity investor underperformance. Not only do fees determine which funds investors choose, but they take a bite out of returns at a higher level than Harvey expected. Other causes include the investor needing cash (planned or unplanned), and lack of availability of cash to invest.
Yet the investor truly is the problem, including being loss averse rather than risk averse. “From an industry perspective, language we use and look at is in terms of risk, like market risk, credit risk, volatility risk,” Harvey explains. “We’ve found investors have a simple view: they don’t want to lose money. We must think in terms of investor pocketbook and not get sidetracked on [risks].”
A Defensive Strategy
Another factor reviewed was the benefits of diversification, which is the touchstone of the investment world. The problem is in major market moves, all markets resort to close correlation. How to combat something that is an outlier?
“You need a defensive strategy that you can communicate to investors,” Harvey says; a passive strategy doesn’t work. “You need to be active and look at the world and take care of it. Also, a fund manager must communicate. If your strategy is so intricate, so complex, the investor won’t understand, they will ignore you. But if you say you have a stop-loss order on, the investor would understand. There are several active strategies that can be communicated effectively that will prevent fear of severe losses.”
Basically, he says investors want a “guarantee,” such as the one the Federal Deposit Insurance Corp. provides for bank deposits. “It doesn’t have to be from the government, it could be some insurance guarantee.” Again, he points out the investors’ fear of losing money more than anything else. He says his firm plans to delve into the guarantee subject in next year’s study.
Jason Hsu, chairman and CEO of Rayliant Global Advisors, generally agrees with the study but notes that due to the methodology, the Dalbar results potentially exaggerate the destruction caused by the investors’ trading of funds. That said, “all evidence points to the qualitative conclusion that investors have eroded substantial returns from their tendency to chase past manager success,” he says. “The return erosion from this trend-chasing behavior appears to be larger than any reasonable manager alpha that could be captured.”
'Like Advising Fish to Stop Schooling'
Robert Prechter, executive director of the Socionomics Institute, which studies social mood and its impact on social action, including the stock market and the economy, and publisher of “The Elliott Wave Theorist,” noted the study has a “correct conclusion.”
“Dalbar is likely correct that investors’ own decisions are way more detrimental to success than conflict of interest, although I would not down play that aspect, as it is real.”
He only questions some of the suggestions on how to avoid bad decisions. “These are mostly old canards, and none of them can work, because investors’ hope, fear and herd [mentality], and no blackboard lesson can change that behavior,” he says. He adds that the advice to “focus on the long term really means buy and hold, which looks good in retrospect but is a bad idea at certain times in history.”
He adds, “Telling investors to avoid doing what they have always done is like advising fish to stop schooling. ‘Become inhuman, and you will be fine.’ It’s true, but the advice is not exactly easy to follow.”
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