Friday, March 27, 2009

Investors Behaving Badly

Even though southern Wisconsin is expecting 3-6" of snow over the weekend, spring must be near as I've been on a mission to clean and organize lately. When I go on these benders, I never cease to be amazed at the articles, magazines, and quotes that I save over time, thinking that they will be of some great value in the future. In addition to helping make cleaning easy, being able to circular-file entire stacks of 'important' saved papers, occasionally my pack-rat nature does provide some interesting reading years down the road. One thing that I dug up last weekend caught my eye, reminding me that history tends to repeat itself through good times and bad.

I had read Humberto Cruz' article "Fear and greed cause investors to lose money" in the Sunday paper which cited the most recent study of mutual fund investor returns by the financial research firm Dalbar. For 15 years Dalbar has analyzed information from the Investment Company Institute and issued an analysis of the buying and selling patterns of investors. The studies consistently find that investors on average do much worse than the advertised performance of the mutual funds they own.

The study concludes that investors tend to sell when the market declines and buy when it increases - buying high and selling low because of emotion rather than logic. "The reality is that investors are not rational and make buy and sell decisions at the worst possible moments," said Louis Harvey, president of Boston-based Dalbar.

The study reported that over the 20-year period ending on Dec. 31, 2008 (including last year's market crash) the S&P 500 stock index returned an average of 8.35% annually. But over that same time period stock fund investors as a whole switched in and out of funds every three to four years, resulting in actual average investor returns of just 1.87% per year.

As I was going through an old 'to-read' box later Sunday night, I came across an industry article I had clipped from October 2003 which cited the 2002 Dalbar study, as well as research from John Bogle and the Bogle Financial Center, as reporting that the S&P 500 index returned 12.9% between 1984 and 2002, while the average equity fund over the same period returned 9.6%. It seems that the article intended to advocate for the superiority of index investing over active management (and indeed this does support that point), but the author goes on to say that average investor in equity mutual funds over the same period got an annual return of only 2.7%!

It was interesting to me to read on the same day about two studies, six years apart, coming to the same conclusion: investors routinely underperform the funds they own by about 7% annually.

My conclusion as a holistic financial advisor: if all I can do is help my clients control their behavior so that they don't panic in bad times - and Lord knows I do much more than just that - I can increase their investment return by 300+% above average.

Good work if you can get it!

Cruz, Humberto. "Fear and greed cause investors to lose money." South Florida Sun-Sentinel, March 23, 2009.
Murray, Nick. "Perspectives on Performance." Nick Murray Interactive, October, 2003.
Bogle, John. "The Emperor's New Mutual Funds." Wall Street Journal, July 8, 2003.

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