The latest DALBAR Quantitative Analysis of Investor Behavior was published recently, and it confirms what we already know: The average investor is terrible at investing.
This yearly report gives an annual insight into the trading decisions of U.S. mutual fund investors. DALBAR has been conducting the study, in one way or another, for several decades, compiling a rich bank of data.
The QAIB report "uses data from the Investment Company Institute (ICI), Standard & Poor’s, Bloomberg Barclays Indices and proprietary sources to compare mutual fund investor returns to an appropriate set of benchmarks. Covering the period from January 1, 1988, to December 31, 2017, the study utilizes mutual fund sales, redemptions and exchanges each month as the measure of investor behavior." Compiling this data gives a picture of the "average investor" and his or her trading decisions across several market cycles.
The average investor underperforms
On the whole, the average investor has significantly underperformed the broader S&P 500 over most periods. Last year, the average equity fund investor underperformed the S&P 500 by 1.19% (20.64% vs. 21.83%), while the average index fund investor underperformed by 0.49%, but outperformed the average equity fund investor by 0.7%.
Over the past 20 years, the performance gap is starker. According to DALBAR's findings, the average equity fund investor achieved an average annual return of 5.3% over the past two decades, compared to a gain of 7.2% for the S&P 500.
In fact, the average equity fund investor only just outperformed the Bloomberg Barclays Aggregate Bond index over this period, which produced a return of 4.6% annualized. The average fixed-income investor, as calculated by DALBAR, had to make do with a return on investment of just 0.44% over the past two decades.
Over the past 10 years, the average equity mutual fund investor has seen an average return of 4.9% compared to the S&P 500's 8.5% and the average fixed-income investor has seen an average return of 0.48% compared to the BloombergBarclays Aggregate Bond Index annual return of 3.31%.
But what's the reason for this significant underperformance? Why is the average investor underperforming so substantially?
Why do investors struggle?
The answer seems to stem from a desire by investors to try and time the market. Last year is an excellent example of how detrimental this can be to investing returns.
DALBAR's analysis shows that throughout the first three quarters of 2017, the average investor was actually outperforming the S&P 500. However, during October and November, as the S&P 500 continued to grind higher, investors started to pull back from equity mutual funds. Unfortunately, by the time they realized their mistake, it was too late. As equity inflows surged during December, equity markets started to weaken. As a result, the average investor missed two of the three best performing months of the year but ended up getting back into the market just in time to take part in one of the most turbulent months of the year.
This evidence reinforces what we have known for some time: The average investor is terrible at market timing, and so too are Wall Street's economic forecasters and commentators. None of them can accurately predict the future.
Another data point that stands out in the QAIB report is the short-term holding periods for many investors. Typically, according to the report over the past 20 years, equity mutual funds investors have "seldom managed to stay invested for more than four years." Between 2008 and 2013, the average retention rate was less than 3.5 years, nowhere near enough for the average investor to feel the full benefits of the recovering bull market.
This DALBAR data gives an excellent insight into what does, or more specifically, what does not work in the market.
Most investors underperform over the long term it seems because their holding periods are too short. That being said, there is also an interesting debate to be had here about the impact fees have on long-term investment performance.
If we assume fees deduct 1% per year from performance, then it does explain some of the performance gap but not all of it. The inability to time the market could be responsible for the rest.
Disclosure: The author owns no stock mentioned.