Despite the education and time spent garnering a deep understanding of the financial markets, I learned a long time ago that a healthy dose of greed or fear can unseat the best laid plans and cause a good investment decision to go south in a hurry. Nowhere is this more evident than in DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) report, which captures individual investor behavior and compares it to an institutional approach. For those of you unfamiliar with the DALBAR QAIB, I’ll recap its findings and suggest an alternative investment approach that we have found resonates with advisors and investors alike.
Since 1994, DALBAR’s QAIB has measured the effects of investor decisions to switch into and out of mutual funds over short and long-term timeframes. Through this analysis, the QAIB has shown that investment results are more dependent on investor behavior than on fund performance. The hope is that by creating awareness about behaviors that cause investors to act imprudently, DALBAR can help improve performance of both independent investors and financial advisors.
QAIB uses data from the Investment Company Institute (ICI), Standard & Poor’s, Barclays Capital Index Products and proprietary sources to compare mutual fund investor returns to an appropriate set of benchmarks. Covering the period from January 1, 1986 to December 31, 2016, the study utilizes mutual fund sales, redemptions and exchanges each month as the measure of investor behavior. These behaviors reflect the “average investor.” Based on this behavior, the analysis calculates the “average investor return” for various periods. These results are then compared to the returns of respective indices.
Summary of key findings
- In 2016, the average equity mutual fund investor (see definition above) underperformed the S&P 500 by a margin of 4.70%. While the broader market made incremental gains of 11.96%, the average equity investor earned only 7.26%.
- In 2016, the average fixed income mutual fund investor outperformed the Bloomberg Barclays Aggregate Bond Index by a margin of 0.19%. The broader bond market realized a slight return of 1.04%, while the average fixed income fund investor earned 1.23%.
- Equity fund retention rates decreased materially in 2016 from 4.1 years to 3.8 years.
- Fixed income fund retention rates increased by almost two months in 2016, inching up from 2.93 years to 3.09 years, eclipsing the 3-year mark for the first time since 2012.
- In 2016, the 20-year annualized S&P return was 7.68%, while the 20-year annualized return for the average equity mutual fund investor was only 4.79%; a gap of 2.89%.
- The gap between the 20-year annualized return of the average equity mutual fund investor and the 20-year annualized return of the S&P 500 narrowed from 3.52% in 2015 to 2.89% in 2016.
- In 5 out of 12 months, investors guessed right about the market direction the following month. While “guessing right” 42% of the time in 2016, the average mutual fund investor was not able to keep pace with the market, based on the actual volume and timing of fund flows.
What does all of this mean?
The research demonstrates that the inability of individual investors to remain invested over time is a big detriment to their overall performance experience. That means investors buy and sell the market at the worst times. The data is pretty clear that a client would be better off holding a diversified portfolio over time, as opposed to trying to actively trade the market.
To correct this problem, investors can either become emotionless when investing (unlikely!) or hire an intermediary who will help put their emotions into perspective and help them remain invested during market turbulence. A trusted advisor’s largest value-add is often being the voice of reason.
Goals-based helps remove emotions from the equation
We’ve been a leader in goals-based investing for 15 years. Goals-based investing starts with breaking client assets into specific, smaller objectives, then planning for those objectives individually. When individual goals are identified and discussed with a client, a greater level of understanding of the expectations occurs naturally, making the decisions that ensue less emotional.
Many advisors have been practicing some form of goals-based investing for decades. But what separates the practice with its full implementation is the ability to create portfolios specifically built to address:
- Accumulation – Growing assets for a future need
- Stability – Protecting assets that have reached a necessary level prior to utilization
- Income – Taking distributions off a portfolio to meet a stated objective
No matter the level of goals that clients bring to the table, they all roll up into these three broader goals. The conversation in this context helps align client expectations with their likely experiences, which helps keep them calm in difficult times.
The final step
As an advisor, continually reinforcing the importance of goal management and realigning expectations with the client on each goal individually helps you have the tough conversations during the worst of markets. In the end, it is the advisors’ ability to talk clients “off the ledge” that allows clients to reach their financial objectives. It isn’t easy, but as my father always said, the most difficult conversations are the ones you have to have.