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Bad Behavior Cost Mutual Fund Investors 8 Percentage Points in 2014: Dalbar

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Calling all conscientious advisors: Dalbar’s latest investor behavior study shows — for the 21st time actually — that investors are their own worst enemies and that good advisors who step up and manage investor behavior can be their best friends.

The Boston-based consulting firm just released its famous Qualitative Analysis of Investor Behavior (QAIB) study, now in its 21st annual edition, and it once again exposes a wide gap between investment returns — the return of a benchmark index — and the much smaller returns that mutual fund investors actually captured.

So, for example, the S&P 500 delivered returns of 13.69% in 2014 but the average equity mutual fund investor brought home returns of just 5.5%, leaving an 8.19-point margin on the table, as it were.

The performance gap was proportionately starker in the case of bond investors. The Barclays Aggregate Bond Index ended 2014 up 5.97%, more than 5 times the 1.16% clocked by the average fixed-income mutual fund investor.

Long-term returns exhibit the same pattern, albeit on a compounded basis. The S&P 500 returned an average of 9.85% per year compared with the 5.19% average annual return of stock fund investors through the 20 years ending December 31, 2014.

Dalbar has always pinned the performance gap to bad investor behavior — such as selling in panic and buying amid the elevated prices accompanying investor euphoria; clearly, gaps of this size result from more than the fact that actual products (vs. indexes) have associated fees.

But the financial services consulting firm usually mines the data for unique insights each year, and its current study draws a line between ill-timed trading and what Dalbar calls “maximum impact events.”

So, looking at cumulative 30-year data, advisors will be unsurprised to find that the months exhibiting the most acute underperformance coincided with market meltdowns or turning points.

The worst gap occurred in October 2008 when the S&P 500 lost 16.8% but investors lost 24.21%, leaving a gap of -7.41 points.

While the report provides numerous insights and conclusions about and for investors, ThinkAdvisor contacted Dalbar president and CEO Lou Harvey to ask about the key lessons advisors can extract from decades of analysis of unremitting investor missteps.

His overriding conclusion:

“We all need a hand to hold at some point,” he says, and it is specifically the advisor’s hand that is needed to restrain investors from acting imprudently during maximum impact events.

Since it is known that these events will occur, even if their timing of course is not known, it is incumbent on good advisors to prepare for them.

Interestingly, and perhaps surprisingly, by preparation Harvey does not at all mean through prior investor education, which he regards as wholly inadequate to addressing the fear felt in real-time when a maximum impact event is occurring.

Rather, the advisor must plan in advance to have calming messages for clients and to deliver them the day, or day after, the triggering event. The messages must be delivered when the fear is being felt, they must relate directly to the event triggering the fear and they must assure recovery.

To any advisors consumed by apocalyptic fears that such a recovery may not take place, the Dalbar report responds:

“Such a possibility would also make the risk of overpromising irrelevant, since the investment business itself would cease to exist!”

More broadly, and beyond the current report, Harvey counsels advisors:

“It is useful to recognize you have three broad types of clients: One is the investor who is simply interested in return; how much you can make for me and the more you make for me the merrier.

“Then you have the protect and grow investor; that’s where the asset allocation [e.g. balanced] funds come in. Frankly [this second group is] the larger group.

“Third, you have clients who say ‘don’t tell me anything, just don’t lose a nickel.’ That’s the safety-conscious investor,” Harvey says.

Harvey opines that risk-tolerance questionnaires work best for the second group — “because they recognize there’s a balance, there’s an upside and a downside. Recognize that you don’t have a homogeny of clients.”

Interestingly, Harvey suggests such questionnaires might be well directed at advisors themselves, so that they can match their own temperament to similar clients.

“If an advisor is all about beating the averages, beating the benchmark, he may not be the best advisor for a Group II person,” Harvey says. “If my role is simply to make you a lot of money, then go after that 15% or 20% of [Group I] investors who have that mindset.”

“Even in that group [i.e., Group I aggressive investors], you’ve got to prepare them and respond [at the time of crisis]. ‘Yes we’re going to put you in highly leveraged XYZ strategy; however, keep in mind it’s going to drop,’” he says.

“You need to have some idea of what is likely to happen, but more importantly, the day it happens, or the day after it happens, is the critical period where we talk about these big momentum events.”

The Dalbar CEO continues that the “good news” is he has seen individual advisors who have embraced their role in managing client fear, thereby achieving success for the clients and in in their practices.

“Unfortunately, they’re overshadowed by the large group that doesn’t do that, who are looking for the latest trick to add to their portfolio of tricks.

“I wish the impact on the way advisors actually ran their practice was much more widespread,” Harvey laments.