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.”
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.
DALBAR found that equity fund retention remained at 4.3 years, identical to 2005 and 2004 retention. This is a positive trend, as investors are earning more for equity fund retention based on their behavior, staying in the market with equity funds, as opposed to fund performance.
Fixed income investors have found that low, long-term rates continue to support long retention in bond funds. QAIB explains that “investors, who exited bond funds… in anticipation of long term rates, found that their market timing was off,” but “investors who moved from bonds to cash did not avoid a crash, but paid a price for safety.”
According to the study, “retention rates for asset allocation investors are substantially longer than either of their equity or fixed income counterparts.” The average retention rate for asset allocation funds is 5.2 years, the study continues. These funds are beneficial because they limit investor losses that occur due to fear based selling, it says. They have created a “comfort zone” for investors to be saved from their own errors.
As well as analysis of current investor trends in regard to various funds, QAIB also features a discussion about its recommended best practices for investors.
QAIB shows that disciplined behavior is more successful than average investor returns by using a test performed to determine if systematic investing through dollar cost averaging is capable of offsetting the choice of a very poor performing fund. Disciplined investing was superior even when using a theoretical fund with returns that were only 75% of the S&P 500. Using dollar cost averaging, a fund that produced only 6.0% beat the average investor returns.
The report also analyzes communicating risk. It states that “behavioral finance, as well as personal experience has established that no other factors influence investor behavior more than the aversion to loss (risk).” Understanding risk results in better investor behavior, affecting the amount of return the investor then sees. QAIB names the three scenarios in which concern about risk is greatest: when an investment decision is required; after a loss; and after news of loss by others. According to QAIB, “These events present the best opportunities for risk education.”