Investor Behavior, Not Market Timing, Matters More in Your Portfolio - Rodgers & Associates
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Investor Behavior, Not Market Timing, Matters More in Your Portfolio

I have been anxiously awaiting the 2012 edition of Dalbar’s Quanti­tative Analysis of Investor Behavior. Since 1994, Dalbar has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds. The results consis­tently show that the average investor earns less – in many cases, much less – than mutual fund perfor­mance reports would suggest. My expec­tation was that 2011 would show that the average investor’s perfor­mance was even worse.

Dalbar uses data from the Investment Company Institute which reports mutual fund sales, redemp­tions and exchanges each month. The study uses this infor­mation to calculate the “average investor return” for various periods based on when the fund was being bought or sold. The return is then compared to the S&P 500 index as a way of measuring the impact of investor behavior.

While giving my mid-year “Pulse of the Market” seminar in 2011, I noted that money was finally flowing back into stock funds. Investors had been net sellers of stock funds since 2008. This trend had finally reversed by July 2011. Unfor­tu­nately, the downgrading of US debt and worries over Europe sent the stock market lower in the third quarter of the year and investors sold billions of their stock funds during the drop. Dalbar reported the average stock fund investor lost 5.73% in 2011 even though the S&P 500 had a gain of 2.12%.


Source: 2012 Dalbar Quanti­tative Analysis of Investor Behavior

This continues a trend of under­per­for­mance that now stretches back 20 years. The average stock fund investor had an annual return of 3.49% for the period beginning January 1, 1992 through December 31, 2011 versus the S&P 500 return of 7.81% per year. Dalbar observed “The average equity investor under­per­formed the S&P 500 by 4.32% for the past 20 years on an annualized basis.” The damage the average investor does to their portfolio by allowing their emotions to affect their investment decisions cannot be overstated. Fear drove investors out of the market in 2008 and again in the second half of 2011. No one would ratio­nally think that buying high and selling low is a good investment strategy. Yet that is exactly what many did. They justified the decision by thinking they would avoid further losses — when in fact they were locking in losses. Losses they could never recover while sitting in a money market fund. This is nothing more than market timing.

The Dalbar report also looks at the effec­tiveness of market timing in what they call the “Guess Right Ratio”. The study again examines fund inflows and outflows to determine how often investors correctly time the market. Investors make money when the ratio exceeds 50%.



Source: 2012 Dalbar Quanti­tative Analysis of Investor Behavior

The Dalbar data shows that average investors do better when the market is generally in an uptrend. They confi­dently add money when the market is rising but give up most of their gains when the market declines. Fear of further declines cause them to sell out or reduce their stock holdings during market declines.

The Dalbar shows that it is not investment fees or being better informed that has the greatest impact on the actual investor’s return; it’s their behavior. Those investors that panicked out of the market at the end of 2008 and early 2009 may never recover their losses. Most of them don’t even realize the losses were caused by their own actions. It is easier to blame the government or Wall Street for your decimated 401(k) account. Some will try to make up for their losses by chasing fads and alter­native invest­ments or other crazy schemes which is just another version of market timing. Others vow to never enter the world of “risky” stocks again and retreat to the perceived safety of bonds. Even if the bond funds don’t lose value when interest rates rise (as they ultimately will), they are losing money to taxes and inflation.

No one can consis­tently time the market. The good news is that market timing is not required to be successful. The financial press would like you to believe that you need to be in the market at the right times and out of it when things are bad. Just keep tuning in for more infor­mation. The truth is that the stock market is driven by many factors of which most can never be antic­i­pated. The very reason the market reacts strongly to an event is the fact that it was not antic­i­pated. News that is antic­i­pated is already priced into the market.

Successful investing requires a long term strategy that acknowl­edges there will be ups and downs along the way. This strategy will take advantage of the down times by rebal­ancing into stocks to capture the lower prices. Success also requires that you prepare for the down times by harvesting off some of your gains while the market is doing well to avoid becoming over weighted in stocks. The Dalbar study revealed the average investor does just the opposite. They added aggres­sively to stocks in up markets and sold in down markets. Buying high and selling low left them with less than half the return they would have gotten from just buying the index and ignoring their invest­ments.

As the stock market approaches a new all-time high, let’s remember the lessons of the Dalbar study and the 2008–2009 market panic. Successful investing has more to do with controlling your behavior. Make sure you have a long-term strategy in place and make a resolution that you will follow it — even when the financial press tells you it’s time to panic.

Rick’s Insights

  • The average stock fund investor under­per­formed the stock market by an average of 4.32% over the last 20 years.
  • The dominate factor contributing to investment results is the investor’s behavior.
  • Studying market reports and economic forecasts to know when to be in stocks or out is just another form of market timing. No one has consis­tently been able to time the market.