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:
|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.
- DALBAR: Quantitative Analysis of Investor Behavior, Advisor "Free Look" Edition, 2010
- Russel Kinnel, Morningstar: Bad Timing Eats Away at Investor Returns
- Morningstar: Investor Returns Fact Sheet