Don’t Underperform Yourself

Prolonged bull markets can lead to false confidence for do-it-yourself investors, financial advisors, and professional institutional money managers.  After all, everyone looks like a genius when stock prices are rising.  History has shown that as market cycles turn, investors make emotional decisions that can have negative effects on investment results.  How can we improve performance by being aware of behaviors & biases that cause investors to act irrationally? 

Enter the annual DALBAR Study (2016 Report).  Since 1994, DALBAR’s Quantitative Analysis of Investor Behavior (QAIB)has measured the effects of investor decisions to buy, sell and switch into and out of mutual funds over short- and long-term timeframes.  The results consistently show that the average investor earns less (in many cases, much less) than mutual fund performance reports would suggest.

In other words, DALBAR tracks average mutual fund investors’ equity, fixed income, and asset allocation returns vs. the actual performance of the mutual funds.  The results show investors dramatically under-perform their own holdings due to their destructive behavior.  Panic selling at the market bottom or failing to get reinvested after the financial crisis would be common examples. 

The 2017 DALBAR Study will be published at the end of April; however, the older reports can be timely reminders to gain perspective and self-awareness.  See our favorite key findings below:

•    In 2015, the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.  For a $1,000,000 portfolio, that’s a difference of $2,336,317 over the 20 years! •    Money Market assets, as a percentage of all mutual fund assets, tend to increase substantially during periods of market downturn but are only reinvested into the market slowly during market recoveries. •    Analysis of underperformance shows that investor behavior is the number one cause, with (excessive) fees being the second leading cause.

How can we avoid being our own worst enemy? A good start would be an honest evaluation of your weaknesses. Do you make irrational decisions during market corrections? Do you fully understand how much risk you are taking? Do you hate losses much more than you enjoy gains? If you answered “yes” to any of the above questions or get uncomfortable during down markets, you are invested incorrectly (check out our cutting-edge portfolio construction tool. Does my portfolio fit me?).

This isn’t to say investors or professional money managers should do nothing during market corrections (although doing nothing is a superior approach to destructive alternatives. See Fidelity’s best performing account owners are dead).  We can make asset allocation adjustments to reduce downside risk.  What we are trying to avoid is large active decisions that derail our long-term investment program.  Raising 50% cash, going to all fixed income at the market bottom, performance chasing etc. 

Do you understand where the risk is in your portfolio?