If the typical mutual fund investor were a racehorse there would be a humane veterinary argument for euthanasia.
Mutual fund investors had a typical year in 2014, according to the annual Dalbar Quantitative Analysis of Investor Behavior study, which is to say they lagged the underlying markets, badly.
The average equity fund investor made just 5.5% last year, compared to a 13.69% return on the S&P 500. Fixed income fund investors earned just 1.16%, despite the Barclays Aggregate bond index rising by 5.97%.
“Perhaps the most compelling evidence that investor behavior leads to poor decision-making is the end result,” Dalbar, which has been performing this analysis for 21 years, said in the report.
“An investor’s goal is to maximize capital appreciation while minimizing capital depreciation. The average mutual fund investor has simply not accomplished either goal.”
The study uses fund sales and redemption and exchange data to impute the performance of an average investor.
It is not as if 2014 was simply a bad year.
Over the past 20 years equity fund investors have made just 5.19% annualized, against 9.85% for the S&P 500. Over 30 years they earned just 3.79% annually in equity funds, only beating inflation by about a percentage point a year. Fixed income fund investors have only made 0.80% annualized a year over 20 years, less than the 2.28% annual rate of inflation during that time.
The problem, it would seem, is that investors try to time the market and get it badly wrong, baling out under stress during downturns and piling in when market strength makes them optimistic.
Over 20 years the average equity mutual fund holder has only managed to stay invested in a given fund for an average of 3.41 years. Again, the problem isn’t likely that investors are switching out of funds at the wrong time in that fund’s life cycle (when for example it changes manager) but rather that the decision to buy and sell a fund is usually driven by market performance. People hang on to equities longer during bull markets and get out more frequently during down markets, the exact opposite of what they would do if they had perfect foresight.
The worst months
A look at the worst months, in terms of underperformance against the market, during the last 30 years nicely illustrates this point. The single worst month was October 2008 when equity fund investors lost nearly 25% of their investment, underperforming broader markets, which themselves were tanking, by 7.41 percentage points. The third-worst month was October 1987, when investors trailed markets by 5.33 percentage points, losing nearly 27% in the month.
This tendency to give in to panic when it is at its worst is extremely destructive.
So, the issue, then, is what should investors do?
There seem to be two broad alternatives: to become a better market timer or to become better at refraining from market timing.
Both of these strategies can involve using an advisor, either one whom you believe will be able to better spot and react to trends, or simply someone who will hold your hand when you panic, stopping you from making what are often the most destructive trades and allocations.
I’d argue that trying to better time markets is a lost cause, especially for the typical mutual fund investor, who themselves won’t have any great insight and who is highly unlikely to come into the ambit of an advisor who is somehow blessed with foresight. Just don’t. It almost certainly isn’t going to happen, and the only people who will definitely benefit if you try are intermediaries.
So the other route, trying to get better at sitting on your hands, is the way to go. I am not here making an argument in favor of buying and holding actively managed mutual funds, as I think you are better off with index funds. If you must buy active funds, buy and hold, and at least get as much benefit from market movements as you can.
Here we come to the value of an advisor. If an advisor can help someone to take on an appropriate level of risk, through asset class exposure, and stick with that allocation, that advisor may be well worth the money, especially when compared to the typical decisions people seem to make on their own.
(James Saft is a Reuters columnist. The opinions expressed are his own, At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
