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Why is much of our advice focused on behaviour??

April 16, 2013

Why is much of our advice focused on behaviour??

The reason is that it is something we CAN control and it matters – a lot!

DALBAR is a quantitative research firm that uses data from the Investment Company Institute (ICI), Standard & Poor’s and Barclays Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks. Covering the period from January 1, 1992, to December 31, 2011, the study utilizes mutual fund sales, redemptions and exchanges each month as a 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. There is very little empirical data on investor’s actual real world performance, so a report from DALBAR is something investors and advisors should understand.

Here are the DALBAR findings:

For the period from 1991 through 2010, while the S&P 500 Index returned 9.1 percent/year the average mutual fund investor earned just 3.8 percent/year. For the same period, bond investors earned just 1 percent yearly, compared with the Barclays Aggregate Bond Index return of 6.9 percent/year.

Source: DALBAR, Quantitative Analysis of Investor Behavior (QAIB) April 2012

Dalbar’s 2012 report, “Quantitative Analysis of Investor Behavior,” showed similar results for 2011, with the average equity fund investors losing 5.73% in 2011 compared to the gain of 2.12% that simply holding the S&P 500 produced. Both equity and fixed income investors underperformed the market on a 1, 3, 5,10 and 20-year annualized basis.

The report states – “The poor performance shows that psychological factors continue to harm the average investor and the remedies for these behaviors remain a work in progress”. The report also says that no matter the state of the mutual fund industry, boom or bust: Investment results are far more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who time the market.

The gross under-performance of the average investor in 2011 clearly displays what has been the case for over twenty-five years – irrational decisions lead to inferior returns. This is not just the case on a year-by-year basis, but for intermediate and long-term results as well. Mutual Fund retention rates suggest that the average investor has not remained invested for long enough periods to derive the potential benefits of the investment markets. Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market.

The question we would have to raise immediately is this: How can an average investor manage to underperform their own investments? If an investment produces a 5% return how can one manage to get less than a 1% return from the same investment? DALBAR says it is not the fault of the investment- after all, the investment has produced a 5% return but the investor has done something to destroy his own returns.

So unlike the media’s fondness for blaming investment performance, there is solid evidence that it’s not generally the fault of the investment – it is the fault of our human brain. Flawed creatures as we are, it is human behavior that appears to be the prime determinate of investment success. It is what we do with our investments after we buy them that is key.

So what are these human factors that get in the way of our success and cause us to make irrational decisions. DALBAR claims that nine psychological factors are likely to be responsible for destroying investment returns and that they must be curbed to produce desirable results for investors:

  1. Loss Aversion: Expecting to find high returns with low risk. Humans are loss averse and internalize a loss much more deeply than a similar sized gain.
  2. Narrow Framing: The way information is framed can determine the outcome. Would you be more inclined to buy something that says it is 10% fat or something that says it is 90% fat free?
  3. Anchoring: Relating to familiar experiences, even when inappropriate. When choosing between investments, people almost always want to know their cost and judge the investment from that point. Investments don’t know what you paid for them.
  4. Mental Accounting: People taking undue risk in one area and avoiding rational risk in others. If someone loses a $100 on their way to a show they are much more likely to attend the show than if they lost a $100 ticket to the same show. Humans tend to keep track of money in silos marked for various things and this can undermine a diversified portfolio.
  5. Diversification: Seeking to reduce risk, but simply using different sources. Buying the same investment from 3 different sources is not generally a diversified strategy.
  6. Herding: The tendency of individuals to follow the crowd. Market bubbles and crashes are primarily due to this factor.
  7. Regret: We tend to avoid making decisions due to regret pain. People regret decisions they have made in their life much more than equally or potentially more important things that they have avoided doing or making a decision on.
  8. Media Response: Tendency to react to news without reasonable examination. Just because you read it somewhere or heard it on television doesn’t mean it is true and/or appropriate for you.
  9. Over-confidence: Belief that you know more than you really do or the tendency to overestimate the reliability of information used in making a decision.

Unfortunately, there is no Canadian equivalent to DALBAR, but to some degree there are similarities between Canadian and American investors. As your advisors, one of our key tasks is to try help you maintain a calm and balanced outlook and help you avoid the type of behaviours that will undermine your chance of success.

It is our strong belief that to be successful in reaching your goals it is necessary to have a plan in place and to follow a process. That is, to make your life and financial decisions not by accident but by design.

Remember, successful people ACT towards the future they want!

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