Insights

The Proof That Most Investors Are Their Own Worst Enemy

06/14/2016

The following blog was originally posted on Forbes.com.

Investors are their own worst enemy. Forget trying to find the next hot trend or stock. It's our built-in psychological biases that lead to bad decisions and ultimately drive our long-term financial success.

There's no better indicator of this than the DALBAR Ratio—referred to by educator Carl Richards as the “Behavior Gap” and Morningstar as “Investor Returns.”

Call it what you will, the idea is simple but powerful: What investors “really get” from their investments is not the officially listed returns on financial websites or a fund prospectus. Instead what investors actually earn reflects all buy and sell decisions over the course of an investment. To say that a fund returned, say, 6.3% per year over the last decade doesn't necessarily mean you earned that exact result. We would have to know when you invested and specific additions or redemptions you made along the way to calculate your actual return.

Unfortunately, for many of us our actual returns don't look as good as the reported numbers. Indeed, the most recent annual report from DALBAR shows the big, unfortunate trend: We investors collectively tend to buy high and sell low. If that sounds backwards, it is. But it’s reality.

Over the past 20 years, from 1996 through 2015, the S&P 500® returned 8.2%. Over the same time period, per DALBAR, the average dollar invested in U.S. equity mutual funds returned 4.7%. To bring those numbers to life, a $100,000 investment in the S&P 500 on January 1, 1995 would have compounded to $483,666 by December 31, 2015. Taking into account the real flows into and out of funds during that period, with annual compounding, that same $100,000 would have been worth $250,573. A majority of that gap between 8.2% and 4.7% is explained by bad buy and sell decisions; fund expenses explain another significant part.

To drive home this point on the importance of good decision-making, let me provide some real world data I stumbled across recently. I purposely say stumbled because there’s some pretty amazing investor behavior data on Morningstar.com—if you can find it. Below I pasted a screen shot of where you can find "Investor Returns" as distinct from “Total Returns."

Source: Morningstar.com.

As Morningstar reports it, total returns are the official returns of the fund, the same you would find in its prospectus. It reflects a strategy of investing on Day 1 and then doing nothing else; it's pure buy-and-hold. You then measure your results at some point in the future. The technical term for this is "time-weighted returns." By contrast, investor returns (or as the wonks would say, "dollar-weighted returns") take into account cash flows—both additions and redemptions.

The Vanguard 500 Fund, arguably the most popular mutual fund in the world as measured by assets under management, provides a perfect test case to see the behavior gap in a natural habitat. Why's that? Because the fund has two main versions which are essentially identical from an investment point of view, but have wildly different patterns of investor behavior. One fund, VFINX, is the "retail" version of the Vanguard 500 Fund; it's what you would likely purchase in discretionary taxable accounts directly from Vanguard or on platforms such as Schwab or TDAmeritrade. It has about $45 billion in assets under management (AUM). The other fund, VINIX, is the institutional version. It is heavily owned in retirement accounts, such as through a 401(k) plan, and has about $200 billion in AUM.

Let me stress this critical point: both funds are identical, with the minor exception of a very slightly lower fee for the institutional version. With this in mind, take a good look at these snapshots of trailing performance for each fund over the last 1, 3, 5, 10, and 15 years, through April 30, 2016.

Source: Morningstar.com, data as of 4/30/16.


Source: Morningstar.com, data as of 4/30/16.

And here’s a clean data table, where I also present (1) the difference between investor and total returns for each fund, and (2) the difference between the investor returns of VFINX versus VINIX.

 

1-Year

3-Year

5-Year

10-Year

15-Year

VFINX: Investor Returns

0.76%

11.65%

10.11%

4.34%

3.21%

VFINX: Total Returns

1.07%

11.09%

10.85%

6.78%

5.36%

Difference

-0.31%

0.56%

-0.74%

-2.44%

-2.15%

 

 

 

 

 

 

VINIX: Investor Returns

1.06%

10.94%

10.79%

7.65%

6.58%

VINIX: Total Returns

1.20%

11.23%

10.99%

6.91%

5.49%

Difference

-0.14%

-0.29%

-0.20%

0.74%

1.09%

 

 

 

 

 

 

Apples to Apples Difference in Investor Returns

-0.30%

0.71%

-0.68%

-3.31%

-3.37%

Data: Morningstar.com, as of 4/30/16.

 

 

 

 

These data lend themselves to a variety of insights. First, I can’t think of a much clearer illustration of the behavior gap in action. Recall: VFINX and VINIX are the same fund, which we can see during comparable time periods. Over the past 15 years, for example, one returned 5.36% per year while the other returned 5.49%—a small gap explained by a small fee differential. But the average dollar invested by a "retail" client annualized at 3.2% for 15 years, earned less than half what was earned by institutional participants.

Second, the real dollar consequence of good versus bad decision-making can be huge. In this particular instance, the average $100,000 investor in VFINX made $160,630 compared to $260,087 in VINIX—a 62% difference. This isn't pie-in-the-sky finance, but significant dollars that can make a difference in our lives.

Third, we can speculate as to why this sizable long-term gap exists. My hypothesis is that investors in VINIX are primarily 401(k) and other retirement plans that are basically dollar-cost-averaging into the market through bi-weekly or monthly paycheck contributions. Thus, they are buying more shares when the market is lower and fewer when it is higher; a slight twist on buying low and selling high. As a result, notice that investors in VINIX outperformed their fund. Meanwhile, more discretion-based investors in VFINX significantly under-performed their own investment. I suspect that's because with more flexibility, these investors succumbed to many of the biases that make the behavior gap so prevalent across many funds.

Finally, the behavior gap is not static. There's a wide range of outcomes in the "apples to apples" comparison. In fact, over the past three years, the investor return for VFINX was larger than it was for VINIX by 71 basis points. Without more data, I can only guess that it's market context that matters here. The past five years have been part of a long, strong bull market. When the market is going up, investors are more likely to want to participate. The 10- and 15-year numbers include a massive market correction, when I'm guessing investors were more likely to redeem in their discretionary accounts than their retirement pools. I see four important takeaways for investors from this little experiment:

  • While there’s an endless, tiresome debate over which investment approach—passive or active—is “better,” these data strongly suggest that it is investor behavior per se more than style that drives long-term success. These are both obviously passive index funds, but with wildly different investor outcomes.
  • That itchy trigger finger is what gets us in trouble. When markets get shaky, we can't but help feel the urge to bolt. It's only natural—literally, our brains are wired this way. But perhaps awareness of this behavior gap phenomenon can inspire discipline.
  • We hold the keys to our own long-term success, even though we sometimes forget that. Regular, consistent, disciplined investing is awesome—especially when it feels like the wrong thing to do. We can see in action how dollar-cost-averaging leads to considerably better results, a strategy reserved for retirement accounts but in all of our investments. A much better investor experience is within our reach.
  • Working with a good financial advisor will increase the likelihood of a better outcome. First, the good ones put you on a sensible plan and make you stick with it through thick and thin. Indeed, their biggest value add is often invisible: keeping you from making big mistakes, such as selling when the market sharply declines.

Past performance is not a guarantee of future results.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.