Shortly after I discovered that I could ride my bicycle no hands it occurred to me that I could stand on the seat. My mother, watching from the yard called out that I was being just a little too cute for my own good. That warning was followed up almost instantly by a memorable crash to the sidewalk. To my credit, I learned from my over confidence and didn’t try that again. But, seventy years later I still have traces of the scar on my chin.
Despite repeated pointed reminders, many investors continue practices that are just a little too cute for their own good. In particular they believe (incorrectly) that they have superpowers as market timers.
The most recent Dalbar study points out that as a result of their superior skill and cunning as market timers the average mutual fund investor lags the market that they invest in by considerable margins.
It’s fair to say that the universe of mutual fund investors is a good proxy for the universe of retail investors.
It’s easy to track the total value of all mutual funds in a category. Just multiply the shares of each fund by its net asset value and add them up. Even an old PC can do that before you can blink.
Cash flows in and out of mutual funds are widely available. So, if we adjust the value of the mutual fund category universe by the value of the cash flows, we can determine the net return that all investors in that category realized during any particular period.
The final step is to compare that returns realized by all mutual fund investors in that category with the appropriate category average or better yet the index.
The Dalbar organization has done this calculation yearly for 25 years with the same depressingly similar results (Quantitative Analysis of Investor Behavior (“QAIB”))*.
Of course, this methodology says nothing about the results of an individual investor, but it captures the results of the “average” investor quite well. And of course, internal fund costs (expense ratios) and frictions will somewhat reduce average fund performance. But nothing close to the order of magnitude we observe.
If we plot the cash flows against market performance a dreary depressing pattern emerges. AFTER the market goes up, investors pour cash into funds (buy high). Then AFTER the market goes down they take it out (sell low). A group of investors are expertly driving their cars in reverse.
We can assume that some turnover is generated by rebalancing, tax avoidance, cash flow needs or other legitimate reasons. But we would also assume that these events are evident in both rising or falling markets. So, that can’t explain the performance gap. These effects are probably only rounding errors in the calculation.
Buy and hold investors should receive the fund category averages, a rather small difference from the index returns determined by average fund expense ratios. It’s the ever so cute delusional market timing investor that drags down the averages.
Mutual funds are designed to be long term investments. Yet the average holding period for funds runs from 2 to 4 years over the last 35 years. As markets rise over time, any time out of the market is highly likely to be an opportunity cost.
But, the average superpower enabled market timing investor is destroying himself/herself by inspired trading. An unmistakable pattern emerges from the data. A class of investors is buying high, selling low, repeating endlessly and wondering why they have such poor results. It goes without saying that this is not the way to profit in the world’s capital markets. Their behavior is just too cute for their own good.
The proof is in the pudding. Average investors underperform in both rising and falling markets. And they do so reliably in every year in every market they enter: large, small stocks, bonds, etc. For instance, in 2018 they underperformed the S&P 500 by 5.04%. Here’s a look at longer term underperformance**:
- 88 percentage points, annualized, over 30 years;
- 46 percentage points, annualized, over 10 years;
- 35 percentage points, annualized over five years.
Similar underperformance shortfalls occurs in each asset class covered.
The staggering magnitude of these underperformances compounded over the years is devastating to the financial well being of investors.
Behavioral economics and psychologists have any number of theories to explain this self defeating behavior: loss aversion, recency, fight or flight, etc. But, there is one very obvious solution: discipline. It’s hard to stay disciplined and keep a long term perspective when the media is bombarding us with noise. That noise attracts our attention and induces us to do something, and doing something is often the worst possible response to headline risk. Presuming you have a well thought out diversified portfolio appropriate to your unique needs, doing nothing is almost always the best course.
Market timing very seldom profits an investor. On the other hand, staying the course has always worked before. When choosing between two strategies, go for the one that’s always worked before.
For the average investor to be successful, they must resist the siren song of market timing and simply stop being too cute for their own good.
*Dalbar: Quantitative Analysis of Investor Behavior 2019
**New York Times