Recently some posts have referred to the Dalbar annual study of investor behavior. I have been following this annual report since its inception and thought I would add my thoughts about it here.
The Dalbar Audience
In order to understand the report first one must take a look at its intended audience. This report is a proprietary illustration sold to the financial planning industry. When you purchase this report, they will brand it with your name, company, etc. It is intended for investment advisors to send out to clients. So at its base it is a marketing piece. Despite this, it does have some interesting data in it. However, the conclusions it was designed to illicit are not necessarily the interesting part and in my opinion are only a partial explanation of what the study demonstrates. This year was an interesting twist in that the report spent much time describing what it calls “allocators,” which are really active investment advisors and funds that allocate capital between different classes of investments. In practical language most of these advisors or funds divide the capital between different mutual funds [bonds, equity, international, industry specific, etc.]
The Top Line Numbers
This year, as it does every year it reports investor performance compared to the performance of stock indexes. I will only use the 20 year data, as anything less adds in noise of short term movements. The indexes they use are the S&P 500 and the Barclay Aggregate Bond Index. For the 20 years ending in 2012 they report average annual returns of 8.21% for the S&P 500 and 6.34% for the Barclay Bond Index. Average investor returns were 4.25% in equity funds, 2.29% in asset allocation funds, and .98% in fixed income funds. So the underperformance for those that were in equity funds was 48% or 3.96% annually. It was even worse for those in asset allocation funds [that generally mix stocks and bonds]and fixed income funds. I will let those numbers sink in a little.
Why the Underperformance?
This is where the analysis in the Dalbar report shows its bias. According to Dalbar the investor results are such because of “bad” investor behavior. For the first time they talk about poor “asset allocators” as part of the problem too [they add that sometimes the asset allocator is the investor]. While there is some evidence of investor behavior creating some of the underperformance, it certainly is not anywhere near the whole story. They present fund retention rates [how long an average investor remains in any particular fund]and they are eye popping numbers. Currently, retention rates have rebounded to 3.7 years!. Retention rates peaked at 4.2 years in 2004-2005-2006, dropped to 3.1 years in 2008, and then starting rebounding to its current 3.7 years. The 20 year average is 3.3 years.They point out that these time periods aren’t long enough to take advantage of the benefits of investment markets.
What the report leaves out is the sequence of return issue. The fact is that when markets go up, the individual investor does close to the index returns. Where the real issues occur is when the market goes down. Investors make their mistakes mostly in down markets [as well as many of the so-called asset allocators]. But even more important is the sequence of returns and when the investor makes their investment. In the Dalbar study it points out that the average investor does better than the systematic investor applying the dollar cost averaging strategy; 33% better.
Sequence of Return Risk Revisited
I have written on sequence of return risk before, but this takes that analysis further.
To demonstrate the reasons we take an exaggerated example. Suppose the stock market doubled in year one and then stayed flat for nine years. Over the 10-year period, the market return is 7.2% a year (“rule of 72″). If an investor invested $1,000 every year in an index fund that exactly matched the market, the investor would have $11,000 at the end of 10 years. Only the first $1,000 doubled. The other $9,000 had a zero return. As a result, the investor’s dollar-weighted return is only 1.7% a year for 10 years.
The big difference between the market’s 7.2% per year return and the investor’s 1.7% per year dollar-weighted return isn’t caused by any performance chasing or bad market timing. The investor is just faithfully investing in an index fund for the long term. When the market did well in year one, the investor simply didn’t have much money invested to catch the good return.
Now suppose the stock market stayed flat for nine years and then doubled in year 10. Over the 10-year period, the market return is still 7.2% a year. If an investor invested $1,000 every year in an index fund that exactly matched the market, this investor would have $20,000 at the end of 10 years, resulting in a dollar-weighted return of 12.3% a year for 10 years. It’s higher than the market return because in the year when the market return was high, the investor had $10,000 invested versus only $1,000 invested in the previous example.
Depending whether the market had higher returns in the beginning or in the end, investors are seen either as dumb or smart even when they made no effort to time the market.[Thank you Henry Sit, “The Finance Buff” for that example].
So our investors over 20 years are suffering from the fact they had more money invested in the last 10 years of poor index performance than the first 10 of great performance causing some of the overall underperformance.
Market Variation is the REAL VILLAIN
What all those financial advisors [asset allocators]haven’t come to terms with is the implications of market variation. The market has dramatic down drafts on average twice a decade, and it has long term bull and bear markets that last on average 20 years [but this is highly variable too]. This high variation does little damage to institutional investors with long investing time spans, but creates extreme risk with the average investor that has 20-30 years of real investing time. Dollar cost averagers underperform those that don’t invest systematically despite the academic theory that they will over perform market timers.
Nowhere does the Dalbar paper discuss real reasons why the average person is in specific funds for less than 4 years. The vast majority of people invest in their companies 401K plans. So when they move jobs or get fired [usually in a recession]they need to move their money into their next companies plans or access money to make it to that next job. People are sold using the average rate of return charts that seem to indicate constant upward movements and most aren’t mathematically astute enough to understand that average rates of returns do not adequately express how much your money is growing [compound returns are needed]. So it is not surprising that some, perhaps a majority of folks are not psychologically capable of withstanding long term bear markets especially the mind numbing market crashes that occur during them.
Sequence of return risk is the hidden secret of the mutual fund industry and you will be well served to fully understand its implications to your retirement investing. You should now understand that by simply complying to dollar cost averaging strategies or simply being consistent serial investors are not the panacea that their proponents proclaim.