Investor behavior has a bigger impact on investment return than fund performance, according to an annual study that examines the effects of investor decisions.
The study, “Quantitative Analysis of Investor Behavior,” was conducted by DALBAR Inc., Boston, and analyzes investor returns for a 20-year period from January 1987 through December 2006 for equity, fixed income and asset allocation funds. DALBAR’s conclusion that investment return is largely dependent on investor behavior echoes the findings from the first study published in 1994.
The report considers behavior including the guess right ratio and retention rates, as well as best investor practices, such as investment selection, retirement savings behavior, and communicating risk in its objective of educating investors on the importance of their behavior and the consequences their decisions have on financial outcomes.
Researchers found that irrational actions, such as loss aversion, narrow framing, anchoring, mental accounting, diversification, herding, regret, media response, and optimism all account for DALBAR’s assertion that the average investor earned significantly less than suggested by mutual fund performance reports. QAIB shows that, “investment returns increase when [these] natural characteristics are replaced by disciplined investment behavior,” and thus, emphasizes that “the most important role of the financial advisor is to protect clients from the behaviors that erode their investments and savings.”
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The guess right ratio, in which the investor accurately predicts the direction of the market, is strongest during periods of rising markets. According to the study, mistakes are made during down turns of the market, as investors fear that the market will not recover. This behavior reiterates the study’s findings that natural characteristics should be replaced with calculated decisions, as QAIB comments that “the really smart decision, that most investors get wrong, is to invest when the market is down.”
In QAIB, DALBAR further analyzes investor behavior, as with the guess right ratio, in its data on retention rates for equity, fixed income and asset allocation.