DALBAR Results Questioned

Ever wonder how the individual investor does versus the market?  Everyone knows someone who made a killing investing.  More often these days, we hear of some maniac up the street who is day trading like crazy.  Ever wonder about your chances?  You ever think of going to the library, checking out 12 books on investing, burning the midnight oil reading them, and then going on CNBC to explain what a genius you are?

Apparently, a lot of people have and it has been going on for a long time.  How do I know?  I know because book stores have been supplied as long as I've frequented them with books that sell well and proclaim to have the secret for beating the market.

This question of whether Joe Blow is beating the market or not is actually a serious question in the investment community.  And it isn't that easy to answer.

One source that has been widely quoted and accepted is an annual study by DALBAR.  They find consistently that individuals underperform by 4% to 5% per year.  Get market returns, a calculator, and a bottle of wine, and spend some time seeing what this under-performance would do to a 20-year investment program; and it will hit you like a sledge hammer that under-performance of this magnitude is devastating!  In fact, you'll likely need another bottle of wine before you're done!

One key point to bring up is that the DALBAR study is expensive, and it is used by money managers to say "if you try to manage your own money, you'll probably screw up; so let us do it for you." (writer's note to self:  I'm not sure that last sentence reads correctly!)  More bluntly, there is an incentive on the part of DALBAR to come up with the kind of findings they report.

Sad to say, I'm in an industry where you have to keep your hand on your wallet and look into incentives at every turn.

A second key point is that it is difficult to decipher exactly DALBAR's methodology.  On seeing their results, any serious analysts would say "wow, I wonder how they got these results."  Good luck in figuring it out.

The relevance of all of this is neatly explained in a guest blog post at the Nerd's Eye View site by Harry Sit of The Finance Group.  The post, Does The DALBAR Study Grossly Overstate The Behavior Gap? examines the impact of the sequence of returns on investment performance and shows how it can produce highly misleading results.

I recommend the post highly - it is readable and you'll come away with a better understanding of investment returns.

Full disclosure:  I have referenced the DALBAR results myself when arguing that investors will do better by sticking to an asset allocation strategy to overcome the negative influence of emotions on the difficult task of successful investing.

Investors' #1 Enemy

DALBAR is a widely recognized research firm that tracks investor performance in mutual funds.  They track when investors go in and out of funds. Year in and year out they find a consistency - investors go in at high prices and exit at low prices.  Over the long run, this costs investors approximately 5%/year on average.  This, from their press report on 2011 results:

While the volatility of the 2011 markets ended with large gains for
bond holders and a small profit for equities, the mutual fund investor did not fare as well.

Equity mutual fund investors gave up on the markets shortly before the year-end recovery and
suffered a loss of 5.73%, compared to a 2.12% gain for the S&P 500. This erodes the long-term gains that began to recover from the devastating losses of 2008.

To see this explicitly and to view it in regard to your own investment behavior, consider the following chart of SPY, the low-cost ETF that tracks the S&P 500 over the past 2 years:

Source: Yahoo Finance

CLICK TO ENLARGE
The letters depict peaks and troughs.  What the DALBAR data finds is that the average investor avoids stocks at "A," piles in at "B," exits at "C," etc.

Look at "C" on the chart, September 2011, for a minute. Congress was squabbling over the debt limit, Europe was on the verge of imploding, and data suggested the economy was possibly heading back into recession. Stocks had just fallen sharply.

CNBC watchers were inundated with pundits overladen with confidence predicting a further sharp downturn in equities.  With each passing day, the emotional investor saw a clearer picture - it was obvious his or her retirement assets were on the verge of taking a beating.  The emotional investors were also kicking themselves mentally for not getting out earlier.  In the face of all the bad "news," the obvious course of action was to back off and seek an entry point when the news was better.

Well, from this point, as the chart shows, stocks went 20% higher!

The important point of the chart is to get the big picture.  Over the period, SPY rose 25%!  How did you do?  Did you get in and out at the wrong time?  Did you sit on the sidelines in money markets at 0.1% complaining, still, about 2008?  If you're the average DALBAR investor, you didn't do nearly as well as the market.

Recent posts on the returns of hedge funds and large pension funds suggest that professionals did poorly as well.  But this is consistent with mountains of data that have reached this conclusion.  Over the long term, less than 20% of market timers and stock pickers outperform the market after fees.  Clearly, they have difficulty controlling emotions in the investment process.

What's the solution?  In my view, it is to focus on an asset allocation that rides out the ups and downs over the long term with well-diversified, low-cost funds.  Oh yeah - this is also the view of Warren Buffett, John Bogle, Burton Malkiel, Charles Ellis, Andrew Hallam, and numerous other giants in the field of investing.

Center for Retirement Research Study

The Center for Retirement Research at Boston College has published a new study arguing that younger investors were hurt more by recent market downturns than older investors. They point out that even despite the dot.com and housing crisis downturns, older investors earned in excess of 8.5% on a conservative portfolio - well in excess of the returns achieved by younger investors since they entered the market. The reason is that the younger investors didn't get the huge push higher from 1982 - 2000.
I haven't read the study so I might be wrong but I suspect that the returns are market returns not actual investor returns. This is important because Dalbar presents data every year that shows individual investors significantly underperform markets because their emotions have them chasing the hottest sectors and capitulating at the worst possible time.
In any event the article did bring to mind a meeting with a potential client a bit over a year ago.  She was upset because her portfolio was at $350,000 and it had been at $325,000. I commiserated with her and said it must be difficult when you've invested $350,000 and experience $25,000 in unrealized losses. All of sudden she straigtened up and said. "I didn't put in $350,000, I had put in $265,000 of my own money". The problem of course is that people compare their portfolios to the peak value. This happens a lot with homes. People wring their hands and bemoan the fact that their house which was valued at $450,000 in 2007 is now valued at $385,000. They forget that they paid $250,000 for it.