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].”
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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. One aspect the average investor got right — at least with equity funds — was beating out those investors who dollar cost average. However, that wasn’t the case with fixed income or asset allocation funds. That also may depend on time period length and market trend.