DALBAR Study Overstates Investors’ Bad Timing

We just passed the two-year anniversary of a recent stock market bottom. Numerous articles in the newspaper and on the web show investors as a whole are dumb. They took money out of the stock market near the bottom and they are now putting money into the stock market after the market recovered almost to its previous peak.

No doubt such behavior exists. How bad does it hurt the investors’ return when they buy high and sell low? The most widely cited study is probably DALBAR’s Quantitative Analysis of Investor Behavior. This study compares the investors’ returns against market returns. Mutual fund tracking company Morningstar also calculates investor returns for every fund and compares them against the fund returns.

Investor return is a dollar-weighted return (or more generically "money-weighted return"). It takes into account the size and timing of investors’ purchases and sales. If investors put a lot of money into a fund and the fund does poorly after that ("buy high"), the investor return will be low relative to the fund’s published return. Same if investors pull a lot of money out of a fund and the fund does well afterwards ("sell low").

The latest DALBAR study shows the investor return in all equity funds in the 20 years ended in 2009 was 3.17% while the S&P 500 returned 8.20% during the same period. It doesn’t say it directly but it implies that investors’ poor market timing cost them 5% a year for 20 years.

I’ve seen this interpretation in many books, including books by respected authors Burton Malkiel, Larry Swedroe and Rick Ferri. While the intention is good — warn investors against buying high and selling low — the interpretation is wrong because comparing investor returns against index returns is comparing apples to oranges. The 5% a year number is so incredible that makes it not credible. The so called "behavior gap" isn’t as high as the DALBAR study implies.

"Buy high sell low" will make investor returns lower than market returns but it’s not the only factor. The pattern of market returns over time also plays a big role. When you see the investor return is lower than the market return, you can’t attribute the difference all to "buy high sell low."

Let’s look at two hypothetical examples.

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 invests $1,000 every year in an index fund that exactly matches the market, the investor will have $11,000 at the end of 10 years. Only the first $1,000 had a good return. The other $9,000 had 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 invests $1,000 every year in an index fund that exactly matches the market, this investor will 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 has higher returns in the beginning or in the end, investors are seen either as dumb or smart even when they make no effort to time the market.

That’s exactly what happened lately. Morningstar shows some mutual funds have investor returns much higher than the fund returns. Here are some examples:

Fund 3-Year Average 
Fund Return
3-Year Average
Investor Return
Vanguard Target Retirement 2045 (VTIVX) 3.08% 8.08%
Fidelity Freedom 2045 (FFFGX) 1.78% 10.74%
T. Rowe Price Retirement 2045 (TRRKX) 4.30% 11.94%

* Source: Morningstar. Data as of Feb. 28, 2011.

Are investors in these target date funds geniuses in timing the market? In addition, are investors in the actively managed Fidelity and T. Rowe Price target date funds smarter than investors in Vanguard funds because they beat the fund returns by a bigger margin? I don’t think so. When the fund return was bad, investors didn’t have much money in these funds. As more money came into the funds, the market had better returns. That’s all.

When you see big positive difference between investor returns and fund returns can be caused by when the market had good returns, you know big negative difference can be an accident of history as well. It just so happens DALBAR’s study period begins in 1990 and ends in 2009. The market had great returns in the first decade and bad returns in the second decade. No wonder there is a big negative difference.

Because DALBAR sells the study to financial advisors to show how investors do poorly on their own, DALBAR has an incentive to exaggerate the effect of poor investor behavior.

To its credit, the latest DALBAR study also shows investor returns of a dollar cost averaging investor. If an investor invests a fixed amount in equity funds every year, the investor return would be 3.44% a year for 20 years, compared to the actual investor return of 3.17% a year. That’s more plausible. Investors lost 0.27% a year due to "buy high sell low."

I would further adjust the dollar cost averaging from a fixed amount every year to an increasing amount every year corresponding to inflation and the growth in the mutual fund industry. With that adjustment, I expect the gap to be even smaller.


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  1. Matthew Amster-Burton says

    Thanks for posting this, TFB. As you know, I got tripped up by the same error, and I’m glad to see your full analysis. Have you contacted anyone at DALBAR for their response?

  2. Max says

    Most individual investors are very passive. They don’t engage in any form of explicit market timing – not even rebalancing. However, they do invest when they have money to invest, which may reduce returns relative to buy and hold if income is negatively related to prospective returns (e.g. income falls in a recession which also depresses stock prices).

  3. Rick Ferri says

    DALBAR is only on study that highlights poor investor performance compared to fund performance. NYU Poly – Department of Finance and Risk Engineering – found that the performance of the average investor in an asset class lags the average performance of the asset class itself by an average of 1.95 percent per year over the past fifteen years, based on net investor cash flows of 25,000 mutual funds. Search for “Past Performance is Indicative of Future Beliefs” on SSRN. In addition, Morningstar has conducted similar study in 2010 and found that over 10 years investors earn 1.5% less annually than the funds they invest in. Vanguard found that advisors suffer the same trend-following behavioral loss in a recent paper titled “Advisor’s alpha”. A recent study of German advisors titled “Financial Advisors: A Case of Babysitters?” came to the same conclusion.

  4. TFB says

    @Rick – Thank you for pointing out the other studies. Do they take into account the market return patterns or growth in new cash due to inflation, economy, or other factors? My hypothetical examples show you can have a lower investor return even though you are just steadfastly investing for the long term.

    I’m not saying investors don’t follow trends or chase performance. I’m just questioning the very high 5% a year number.

  5. Rick Ferri says

    TFB, I see your point and couldn’t tell you precisely how much of this loss is due those factors. My experience tells me there’s about a 1% shortfall from market-timing/sector rotation in the broad average DIY investor or advised portfolio. For more clues, you could sniff out Vanguard and TIAA-Cref asset allocations for retired 401k participants who are not putting in any more money. When I looked at this several years ago, I found some moderate shifting taking place at the wrong times. IMO, there is definitely a behavioral cost.


  6. Ice-9 says

    Very interesting article and topic, as well as the comparable stats from Rick’s comments. My anecdotal response is I know many people who trailed the market by a lot more than 5% selling everything in early 2009.

  7. Kathryn C says

    It’s a good lesson in general: when one option looks like a “no brainer” – in this case the overstated investor returns – it’s time to take a step back so we can look under the hood.

    Unfortunately people with advisors probably have little financial knowledge (that’s why they go to the advisor) so they don’t catch these red flags, unless they’re reading your blog. I enjoyed this article, thank you

  8. Chad says

    Interesting post and discussion! I think your point is valid, but I’m not yet convinced that very much of the difference between fund performance and investor performance is caused by dollar-cost-averaging.

    How large were the average annual inflows relative to the amount invested in the funds at the start of the study?

    As shown in your example, dollar-weighted and time-weighted returns can be very different if an investor starts at $0 and pays in $1000 per period over 10 years. However, if the investor’s starting balance was $100,000 and he paid in $1000 each year, then the money-weighted and time-weighted returns would be much more similar since the initial balance, which was invested the whole time, dominates.

    Similarly, I think time-weighted and dollar-weighted returns for a large set of mutual funds over a 20 year period should be very similar in the absence of behavioral effects. The number of dollars already invested in the funds at the beginning of the evaluation period would be large relative to the average yearly inflow, and the investors who were dollar cost averaging into the funds would have been partially offset by investors who were drawing down retirement savings.

  9. TFB says

    @Chad – Yes, a beginning balance should be accounted too. According to 2010 Investment Company Fact Book there were $3 trillion invested in all funds at the end of 1995. That number was $12 trillion at the end of 2009, a 300% increase. It’s not all due to investment gains. Although you do see net inflows increase when the market did well and decrease when the market did poorly, on average the net inflows are not trivial. For example, $3 trillion invested at the end of 1995 turned into $3.7 trillion at the end of 1996. Nearly half of the change was due to net inflows ($321 billion). The rest was investment gains.

  10. Mike Holman says

    This is excellent. Like you, I always viewed the Dalbar report with suspicion, since it is sponsored by an advisor group – plus the results didn’t really make sense.

    There just aren’t that many active investors to get the results they show.

  11. DIY Investor says

    Interesting post. This should definitely be tied down. Does Dalbar use dollar weighted returns to calculate their results? In terms of timing they should use time weighted returns.
    I, for one, have no problem believing their result. Whether it is under performance 5% or 3% I don’t know but I believe it is significant.
    There are of course many investors who feed their 401ks and stay pretty much with a basic allocation. To me these are not the people we are talking about. If we had the Feidelity or Vanguard data we could easily identify these investors.
    Others trade actively. They analyze the macro economy and try to pick the hot sectors, switch from stocks to bonds, move from domestic to international, jump into internet or commodities etc. I believe that these active traders, on average, underperform by a lot.

  12. David says

    This goes back to the Monte Carlo problem. I’m wondering how accurately you can even predict returns or explain why investors do well or poorly. Mutual funds add other variables that make it tough to say whether the fund is good or bad long-term. How much cash is set aside for redemption, for example? This would be money not invested, which affects returns. Interesting that your research showed higher than posted returns.

  13. Investment Fiduciary says

    Interesting critique of a good study. I hope future research would take into account of your critique.

    I am quite convinced of negative investor alpha, though the magnitude of which is open to debate. It is also important to point out that it is possible to achieve positive investor alpha if the investor is disciplined about rebalancing.

  14. WDW says

    I believe investors in general lose out due to behavior and market timing, but have also been skeptical of the Dalbar numbers. However, I’m not sure you’re argument completely holds water. Dalbar has been doing this study for awhile now and if you look at the Dalbar 2001 study http://www.feesonly.com/Articles/Dalbar%20Study.PDF
    it shows nearly an 11% discrepancy in investor and equity index performance from 1984 to 2000. Although returns were consistently strong during this time period, the returns during the last 5 years of the study were really high. Using the dollar weighting logic in the article you would think the investors would at least be closer to the performance of the equity index. Obviously, dollar versus time weighting will impact the results but the question is by how much?

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