It is an accepted belief that retail investors, swayed by a barrage of financial news and information, and the wiring in their own brains, tend to systematically buy at market peaks and sell at market lows, resulting in returns that are far lower than what could have been achieved by simply buying and holding. This so-called "behavior gap" has been quantified most famously over the years by DALBAR, which produces and annually updates a study of the difference between investor (dollar-weighted) returns and index (time-weighted) returns, and currently shows that investors have cost themselves more than 4% per year in returns for the past two decades. Yet the reality is that DALBAR's methodology confounds the impact of investor behavior, and the simple consequences of return sequences; it's entirely possible that some or all of the low DALBAR investor returns are simply due to the fact that markets rose for the first half of their time sample (the 1990s) and were flat for the second half (the 2000s). And in fact, that appears to be the case. Once DALBAR updated their projections to compare investor returns to a passive investor who simply invested systematically over the entire time period, the result surprisingly shows that retail investors in the aggregated actually outperformed systematic dollar cost averaging for the past 20 years!
The Behavior Gap
With the recent surge in the stock market, S&P 500 with all dividends reinvested has reached an all-time high.
Numerous articles in the newspaper and on the web typically show retail investors as a whole are "dumb" and imply that they took money out of the stock market near the bottom and are now putting money into the stock market just as it makes new highs.
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 (time-weighted) return. Similarly, if investors pull a lot of money out of a fund and the fund does well afterwards ("sell low"), investor returns will lag.
The latest DALBAR study shows the investor return in all equity funds in the 20 years ended in 2011 was 3.49% a year while the S&P 500 returned 7.81% a year during the same period. This suggests that the average equity investors' poor market timing cost them 4.32% a year for 20 years - a gap in performance due entirely to their own harmful behaviors.
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 4% a year number is so incredible that it makes the number not credible. The so called "behavior gap" isn't as high as the DALBAR study says.
Flawed Methodology For Measuring The Behavior Gap
The reason the DALBAR study is incorrect is that while "buy high sell low" will make investor returns lower than market returns, it's not the only factor. When using dollar-weighted returns, the pattern of market returns over time also plays a big role. Consequently, when you see the investor return is lower than the market return, you can't necessarily attribute all (or possibly even some) of the difference 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 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.
That's exactly what happened lately. Morningstar shows some mutual funds have investor returns much higher than the fund returns. Here are some examples:
|5-Year AverageInvestor Return||Investors Outperform|
|Vanguard Target Retirement 2045 (VTIVX)||1.09%||4.35%||+3.36%|
|Fidelity Freedom 2045 (FFFGX)||-0.08%||5.43%||+5.51%|
|T. Rowe Price Retirement 2045 (TRRKX)||1.52%||5.53%||+4.01%|
* Source: Morningstar. Data as of Aug. 31, 2012.
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. The measured 5-year period starts in 2007, before the crash. 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.
DALBAR Results More Sequence Of Returns Versus Bad Timing
When you see that 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 1992 and ends in 2011. The stock market had good 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. The 2012 edition of the study also includes some contrived arguments against the fiduciary standard. It's off topic for this post but it also reflects where DALBAR's allegiance is.
To its credit, the latest DALBAR study also shows investor returns of a dollar cost averaging investor. If an investor invested a fixed amount in equity funds every year, the investor return would have been 3.17% a year for 20 years, compared to the actual investor return of 3.49% a year. The average investor beat dollar cost averaging! Why isn't that the headline?
- DALBAR: Quantitative Analysis of Investor Behavior, Advisor "Free Look" Edition, 2012
- Russel Kinnel, Morningstar: Bad Timing Eats Away at Investor Returns
- Morningstar: Investor Returns Fact Sheet