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Investor Education Is ‘Futile,’ ‘Totally Discredited’: Dalbar

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Like Bill Murray’s character in Groundhog Day, it seems that average mutual fund investors are condemned to grossly underperforming the market year after year.

Indeed, in its soon to be released annual Quantitative Analysis of Investor Behavior (QAIB) report, Boston-based Dalbar has the unpleasant Phil Connors-style duty of reporting the same conclusion year after year — and this report, Dalbar’s 20th, offers a bracing conclusion:

“Attempts to correct irrational investor behavior through education have proved to be futile. The belief that investors will make prudent decisions after education and disclosure has been totally discredited. Instead of teaching, financial professional should look to implement practices that influence the investor’s focus and expectations in ways that lead to a more prudent investment decisions.”

Though 2014 marks QAIB’s 20th edition, Dalbar’s first report dates to 1984; as a result, Dalbar now has 30 years of data measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds.

“The results consistently show that the average investor earns less — in many cases, much less — than mutual fund performance reports would suggest.

(The QAIB references index returns because of their wide acceptance, whereas equity fund returns can be calculated in very different ways, Dalbar informs ThinkAdvisor.)

So over the 30 years from QAIB’s inception to the 2013 market close — a period encompassing the crash of 1987 and subsequent market booms and busts — equity fund investors earned an average annual return of 3.69% compared with the S&P 500’s 11.11% return.

In last year’s robust equity markets, the average equity fund investor saw large gains — with average performance of 25.54% — but those results fell far below the S&P 500’s 32.41% return.

A “silver lining,” says Dalbar, is the improvement seen since the severe return-chasing behavior of the dot-com era:

“In 1999 the long-term annualized return of the equity market was 2.5 times that of the average equity mutual fund investor (18.01% vs. 7.23%).”

But whether then or now, the essential problem is that investors tend to sell after experiencing paper losses and return to investing after markets recover their value.

“The devastating result of this behavior is participation in the downside while being out of the market during the rise,” Dalbar says.

Given the persistence of this performance gap, this year’s edition of the Dalbar report focuses on ways that financial advisors can help investors avoid losing money through poor timing decisions.

“After enormous efforts by thousands of industry experts to educate millions of investors” that Dalbar says have been “ineffective,” the consulting firm recommends four key best practices for financial professionals: set expectations below market indexes, control exposure to risk, monitor risk tolerance, and present forecasts in terms of probabilities.

The first strategy derives from the idea that inappropriate investor actions stem from inappropriate expectations.

Since the market is a zero-sum game in which every trade’s winner is balanced by a loser, and furthermore since institutional market participants have advantages over retail investors, Dalbar asserts that “the average investor cannot be above average.”

The second strategy is to emphasize capital preservation through purposeful allocation of some portion of the portfolio to lower-volatility investments. Says Dalbar:

“The market of 2008 was a time when capital preservation became more obvious and highly appreciated. In this year the average equity mutual fund investor lost over 40% of their value, again trailing the market. Mutual fund investors that were invested in asset allocation funds that utilized varying degrees of capital preservation strategies beat the market that year.”

The S&P 500 lost 37.72% in 2008, better than the average equity fund investor who lost 41.66%. By contrast, the average asset allocation fund investor lost 30.53%.

To facilitate risk control, Dalbar recommends that advisors utilize alternative reporting schemes that reframe investing in relation to client goals rather than average market returns.

“Explicit, reasonable expectations are best set by agreeing on a goal that consists of a use of funds, a dollar amount and a date. Progress to meeting that goal is then tracked, showing how much the investor is ahead or behind the established goal…Linking the investment to a personal desire keeps the attention focused on that desire and avoids the distraction of market volatility that leads to bad investment decisions,” the Dalbar report states.

A third best practice is for advisors to monitor risk tolerance, understanding that it is not rational, homogenous or stable. Investors’ tolerance is filtered through their experience and the experience of others; it can vary depending on the purpose of various funds, for which reason Dalbar recommends multiple asset allocations; and new experiences and new purposes can change a previously established risk tolerance, requiring constant monitoring on the part of the advisor.

Finally, Dalbar says it is wrongly assumed that specific asset classes carry a constant level of risk, whereas various predictive conditions result in widely varying probabilities.

For example, over the past 25 years, there was a 10% chance of a 1% loss in the next month following one up month but a 19% chance following two down months. Moving around various time predictive conditions, time frames and asset classes will yield vastly varying percentages.

“Ultimately, this confusion sets the stage for investors’ irrational action when a market correction occurs,” states Dalbar, adding that “the cure for this dilemma is truth.

“The truth is that the numbers are not hard but each has a probability of occurring. Measuring and assigning a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.”

The sophistication this requires highlights the futility of investor education, which Dalbar says has involved the presentation of ambiguities and instruction in “an arcane language to uninterested consumers.”

Moreover, such efforts serve “to transfer responsibility from the expert to the unwitting neophyte” that “relieve the expert of any responsibility” — an approach that may successfully defend against litigation or arbitration but which does not improve investor decision making.

“Investors generally have two interests, one is making money and the other is not losing it. Trying to explain the difference between a stock and a bond is unconnected to those interests,” Dalbar states, concluding:

“The future success in the investment business will belong to those who manage prudently and relieve investors of the burden of learning the business themselves.”

Reached by ThinkAdvisor, Dalbar’s president and CEO Lou Harvey had this to say about this year’s QAIB:

“It is astounding that after all the evidence of failure to teach investors to make prudent decisions, the belief still remains that more spending on education and disclosures will eventually work,” Harvey said. “It seems that there has to be a massive lawsuit before we abandon the practice of requiring novices to make complex investment decisions.”


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