Yesterday we noted the perils of performance-chasing, especially in an illiquid asset class like residential real estate. But behavioral errors matter in liquid asset classes too. Consider the well-known evidence compiled by Boston-based Dalbar, Inc.
From 1986 to 2005, the average annual return of the S&P 500 was roughly 11.9%. Not bad! Unfortunately, the average equity mutual fund investor earned only 3.9%, outpacing inflation by a scant 0.9%. Why? Investors tend to chase performance in uptrending markets and bail out in downtrending markets. Here's the accompanying commentary from Dalbar's 2006 report:
Improving investors' actual returns depends more on correcting behaviors than on the performance of the fund.
While published statistics of mutual fund performance are within a few percentage points of the index, investor behavior erodes the returns on even the best performing fund.
Investors in fixed-income funds also underperformed: 1.8% annually, against 9.7% for the long-term government bond index (and, again, 3% inflation). What about investors who chose asset allocation funds? Not a pretty picture here either: 3.3% annual returns. In risk-adjusted terms (in other words, because asset allocation funds had cash and fixed-income components that underperformed equities in this period), the picture here is a little brighter, but truly just a little.
We were reminded of the Dalbar results by the inaugural issue of Morningstar Advisor, a new magazine published for investment advisors. Unfortunately, the story is not available online, but "Your Mileage May Vary" provides additional evidence of the effects of behavioral errors on bottom-line returns. (The methodology behind Morningstar's "Investor Return" calculations is described here.) Morningstar's key points are that more volatile funds and asset classes tend to exacerbate the effects of investors' buy high/sell low tendencies.
In our White Paper on the value of good professional help, we describe the five key factors in investment outcomes:
- Asset allocation
- Investment discipline
- The performance of one's chosen investment vehicles
- Taxes
- Expenses
The first two are overwhelmingly the most important and while the order of the last three can vary, together these five factors are the ingredients of success (when investors get 'em right) and failure (when investors get 'em wrong).
Because asset allocation and discipline are as much behavioral as technical, investors need to understand the enormous impact of emotion on their investment outcomes.
Markets tend to be pretty darn efficient over the long-term, but scholars working in the field of behavioral finance have established that investors, who tend to operate on shorter time horizons, are not always the rational calculators of traditional economic theory. Research findings from Dalbar and Morningstar leave little doubt: getting the behavioral stuff right is the foundation for investment success.
