Reduction in 401(k) limits possible

One of the good things to come from the current recession is that inflation has been virtually non-existent and we've even seen a reduction in the cost of living depending on the time frame measured. Through September 2008 inflation was just under 5% due to energy costs, but we've had deflation since March 2009. While this is good on the pocketbook, the IRS may be forced to reduce the maximum contribution from its current $16,500 (plus $5,500 for those over age 50) because the 401(k) law bases contribution limit increases on the Consumer Price Index's measure of inflation.

The law is a bit gray in this area, as this has never happened before. But with the average 401(k) plan balance down over 25% in 2008, a reduction in the contribution limit could hinder the ability to buy more shares at lower prices - cutting at the heart of dollar cost averaging.

A five-minute email to your representatives in Washington can help the opposition to this possibility.

Pitt, David. “401k contribution limits face potential fall.” Atlanta Journal Constitution, September 4, 2009.

Block, Sandra. “In 2010 IRS could cut 401(k) contribution limit to $16,000.” USA Today, August 28, 2009.

True Investor Returns, Pt II

After writing the last post, I was curious about the actual results of previous studies and decided to do a little digging about the history of the DALBAR anlaysis of investor vs. fund returns. My gut agreed with Nick Murray's contention that the underperformance of investors vs. funds remained fairly constant (in all the time I can remember seeing the survey results since I started in the financial business in 1994 that seemed to be the case), but I wanted to verify that. I did some googling and found these excerpts taken from the public pages of DALBAR's website, proving that this is not a new phenomenon.

From the 2001 update page

QAIB (Quantitative Analysis of Investor Behavior) examines real investor returns from equity, fixed income and money market mutual funds from January 1984 through December 2000. The study was originally conducted by DALBAR, Inc. in 1994 and was the first to investigate how mutual fund investors' behavior affects the returns they actually earn.

The following annualized returns for investors, whose average fund retention was 2.6 years in 2000 (down from 2.8 in 1999, but up from 1.7 after the stock-market crash in 1987), compared to corresponding indexes, clearly illustrate the benefit of buy-and-hold strategies:

• The average fixed-income investor realized an annualized return of 6.08%, compared to 11.83% for the long-term Government Bond Index;
• The average equity-fund investor realized an annualized return of 5.32%, compared to 16.29% for the S&P 500 Index; and,
• The average money-market fund investor realized an annualized return of 2.29%, compared to 5.82% for Treasury Bills and 3.23% for inflation. Money-market fund investors lose money after inflation.

From 2003

Motivated by fear and greed, investors pour money into equity funds on market upswings and are quick to sell on downturns. Most investors are unable to profitably time the market and are left with equity fund returns lower than inflation.

• The average equity investor earned a paltry 2.57% annually; compared to inflation of 3.14% and the 12.22% the S & P 500 index earned annually for the last 19 years.
• The average fixed income investor earned 4.24% annually; compared to the long-term government bond index of 11.70%.

From 2004

It is widely believed that rapid fire trading produces huge profits for traders at the expense of the average investor. But the latest DALBAR study shows that market timers actually lose money instead of making healthy profits.

Examining the flows into and out of mutual funds for the last 20 years, the DALBAR study of investor behavior found that market timers in stock mutual funds lost 3.29% per year on average. Over a period when the S&P grew by 12.98%, the average investor earned only 3.51%.

“This finding is consistent with the well known behavior of investors to brag about their gains, but remain silent about losses” said Lou Harvey, DALBAR President. “The occasional money makers create the illusion that all timers are winners all the time. The fact is that most timers lose money most often and this data now confirms it.”

The study for the 20 years ending 12-31-2008 didn't have a public page, but the updated results showed equity investor annual returns of 1.87% versus S&P 500 index returns of 8.35% and fixed income annual investor returns of 0.77% versus the Barclays Aggregate Bond index returns of 7.43%.

True Investor Returns

In a statistic that never ceases to amaze me, research firm DALBAR calculates that the average investor return is consistently less than half of the return of the average mutual fund. I was reminded of this twice recently: first in reading Nick Murray's book "Behavioral Investment Consulting," in which he cites the 2007 version of the DALBAR survey as calculating the average equity fund investor having a 4.48% return versus the average equity fund realizing a 10.81% return over the previous 20 years. Every year that I've seen this study the results have been pretty consistent, and Murray says in his book that "...although these two numbers will bounce around a lot from year to year, the relationship between them remains eerily constant: over 20 year periods, the average fund investor consistently manages to capture much less than half of the return of the average fund." (emphasis his)

The second reminder of this phenomenon came in an article on Morninstar.com titled "Did You Do As Well As Your Fund?" I have not reviewed Morninstar data on this topic previously, but since 2006 the firm has been calculating Investor Returns in comparison to Fund Returns. This article has a very enlightening analysis of popular funds such as CGM Focus and Fairholme in relation to the exceedingly poor investor returns relative to total fund performance.

Morninstar calculates that investors in Fairholme have received a -1.68% return over the past five years compared to Fairholme's 8.56% fund performance over the same time period. CGM Focus investor's return underperformed the fund by a whopping 20% over the past five years! (And that's not 20% total, that's 20% annually!)

More evidence that we don't need to have an accurate prediction of the future to have a good investment experience, we just need to have a good plan and stick to it.

Trust Your Intuition?

A colleague of mine in the Alliance of Cambridge Advisors recently received this email from a client in reference to a blog post from the Wall Street Journal, which interviews author David Adler:

Dear ____,

In case you missed this, popular research is finally catching up with where you've been for years. "Behavioral portfolio" and "asset location" to maximize tax advantage sound like you, today - and 20 years ago!

Hope you're well,

_____

It certainly is nice to see the fundamentals of our ACA philosophy beginning to achieve mainstream validation. Especially the ideas that internal (endogenous) factors such as behavior impact personal wealth much more than external (exogenous) factors such as interest rates over which an individual has no control and that managing taxes with asset location is at least as important to resulting wealth as asset allocation. Both are great examples of the differences between an investment manager and a financial planner: true financial planners are more intersted in achieving bottom-line client goals than gross investment returns.

I do take issue with one comment by Adler that "...the idea that the markets are so rational that we don't have to touch them? That idea is gone." As pointed out in our July teleseminar "Why the Smart Money Indexes" even though the S&P 500 is down for the decade ending 12-31-2008, a diversified index portfolio was up 40-60% depending on the mix of stocks and bonds over that same time.

Adler is right that the markets aren't always rational 100% of the time, but over any reasonable invesment time horizon they tend to be. Moreover there is no evidence that anyone has the skill to predict when they are and when they are not accurately priced. So even though in reality, and certainly in the short term, the markets are not perfectly efficient, investors are best served by acting as if they are.