Each year, the research firm DALBAR publishes their Quantitative Analysis of Investor Behavior. Every year, the results show that individual investors are their own worst enemies.
And this year is no exception.
The QAIB examines the real returns earned by investors in equity mutual funds, bond mutual funds, and asset allocation mutual funds. Over the past twenty years, the average investor in an equity mutual fund has under-performed the S&P 500 Index by an annualized 4.3% per year. The S&P 500 returned an average of 7.81% for the 20-year period through 2011, but the average equity fund investor generated only 3.49% per year.
And unfortunately, the news just gets worse: In 2011 alone, the average equity fund investor generated -5.7% vs. the S&P 500 which generated 2.1% return (an under-performance of 7.85%). Investors in bond funds did far worse. Compared to the Barclays Aggregate Bond Index which has a trailing 20-year annualized return of 6.5% per year, the average investor in a bond fund gained an annualized return of only 0.94% per year over this same period. Investors in bond funds underperformed their benchmark index by -5.56% per year.
Investors Still Buy High and Sell Low
These results are astronomically bad and the results from the 2011 DALBAR QAIB is just one more piece of evidence that investors are not making the right choices. Sure, fund expenses are part of the problem, but for the majority of individual investor’s the underperformance can be blamed on bad timing decisions. This is nothing new to professionals who study investor behavior: Investors invariably get out of the market after a decline and jump back in after a rally. In other words, they tend to buy high and sell low.
I wrote my summary of these issues back in May 2008, almost exactly four years ago. At that time, I estimated that the average loss due to bad timing by investors was 3% per year for an investor with a portfolio made up of 60% equities and 40% bonds. Over the most recent five-year period, the DALBAR QAIB reports that the average equity fund investor has trailed the S&P 500 by -1.96% per year. The average bond fund investor has trailed the bond index by -5.55% per year.
If we take the equivalent proportions (60% equity and 40% bonds) and estimate an aggregate underperformance over the past five years, we get 3.4%. The closeness of this number to my estimate is, no doubt, partly coincidental. In my 2008 article, I noted that the range of evidence suggested that bad timing was a major culprit in the poor performance experienced by retail investors. Individual investors buy equity funds when they are optimistic and sell when they are worried, and DALBAR’s annual QAIB surveys are an ongoing validation of that observation. The average mutual fund equity investor holds a fund for an average of 3.3 years. For bond fund investors, the average holding period is less than 3 years. The DALBAR QAIB report shows that the flow of investor money into or out of the market is timed poorly.
Buy and Hold Investing: Don’t Throw in the Towel
Many investors have simply thrown in the towel on the idea of buy-and-hold investing because they believe that buy-and-hold has failed as a strategy. This is simply not true. A buy-and-hold investor in Vanguard’s S&P 500 Index Fund (VFINX) has an annualized return of 10.6% per year since its inception in 1976. Vanguard’s Total Bond Market Index (VBMFX) has returned an average of 6.8% per year since its inception in 1986.
These returns do not, of course, mean that these funds or their underlying indexes will return anything similar to these levels over the coming years. And I am not saying that buy-and-hold is the only right strategy. What I am saying is that the pundits who say that buying and holding a low-cost portfolio has historically been an unsuccessful strategy are simply looking at shorter time horizons. Using data in the QAIB report, for example, we see that the S&P 500 has an annualized return of 2.92% for the last 10 years and 7.81% per year for the last twenty years. And this tells the story. Nobody will be complaining if the market returns 8% going forward, but even if that is the case, how many investors could stomach another decade of returns below 3% along the way?
What’s the Take-Away Here?
First, I want to reiterate that there are many ways to create successful investment strategies, and individual investors’ efforts to time the market have been a notable and horrendously expensive failure. This does not mean that there are no successful ways to change allocations as a function of market conditions (this is called “tactical asset allocation”). The DALBAR results do not mean that investors should simply hold a stock index fund and a bond index fund. While this approach has delivered attractive returns over sufficiently long periods, we cannot simply assume that we will be the fortunate recipients of high returns rather than low returns.
Perhaps more specifically, even if the long-term future average return of the S&P 500 is 8%, we must understand that we might still be the unlucky recipient of returns far below this level over decade-long periods. Investors twenty years ago did not have any assurance that their investments in stocks would average out to close to 8% per year. Even given our uncertainty with regard to the future returns from equities, there are several things we can do to improve our future prospects and perhaps the most important is to make a strategy and stick to it, avoiding jumping out of the market because we are feeling panicked or jumping in because the market appears to be rallying.