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Monday, August 6, 2012

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

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.

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