DALBAR 2014 Quantitative Analysis of Investor Behaviour

posted on June 27th, 2014 by Peter

2014 marks the 20th instalment of DALBAR’s ‘Quantitative Analysis of Investor Behaviour’ survey – an insightful look into the long-term performance of both investment markets, and the investors in those markets. Since 1994, DALBAR has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds (equivalent to Australian managed funds), and examining the aggregate result – to determine the average returns earned by investors during that period, compared with those of the underlying market.

Once again, the news isn’t good, with the average US equity mutual fund investor achieving average annual returns of 5.02% per annum over the last 20 years, compared with the 9.22% per annum return of the S&P500 index over the same period. To put that into perspective, an investor who invested $100,000 in the S&P500 20 years ago would today have a total portfolio of around $583,503 – compared with only $266,342 for the average investor in US equity mutual funds. The net difference of $317,161 represents the horrendous net cost to investors of their buy and sell decisions during that period.

Investors no doubt believed that their buy and sell decisions were perfectly rational, based on the information available to them at the time. But overwhelmingly, the evidence suggests that investors’ attempts at market timing are woefully ineffective – tending to sell after periods of poor performance, and entering the market again only after they have recovered their value. The devastating cost of these attempts to time the market – equating to 4.2% per annum, far outweigh any other single factor – including manager selection, fees, or taxes, to be the single biggest drain on investor performance in the long term.

DALBAR 2014 investor returns

So, what can we learn from this to help our clients maximise their long-term investment returns? In my opinion, it boils down to two key factors:

1. Realistic expectations

It’s vital that investors have a realistic understanding of likely long-term returns from the equity markets – based not on short term, recent history (most investors have a ‘recency’ bias – with expectations for future returns strongly anchored to short term results in the recent past), but based on long term returns – which are inevitably tied to the performance of the economy as a whole, and aggregate levels of corporate profitability.

Just as important as long-term returns though, is that investors have an understanding and acceptance of short-term volatility. Whilst the Australian equity market has achieved a creditable average return of 9.1% per annum over the last 20 years, returns have actually been negative in four of those years – and this in a period when the Australian economy hasn’t suffered from a single recession! Only if an investor has an inappropriate investment horizon, or attempts to time the market is this short-term volatility detrimental. A realistic understanding and acceptance of this short-term volatility is essential for clients – and the time to set these expectations is when the client is first investing, not only after the market has just fallen!
At Bellmont, by adopting a systematic approach to the construction of our portfolios, rather than being subject to the fallibility of individual portfolio managers, we’re able to provide investors with far more realistic expectations regarding their likely future returns in various market conditions.

2. Alignment of risk tolerance and investment selection

The DALBAR study highlights that the number one thing an adviser can do to improve the long-term returns of their clients is to ensure that they are invested for the long term!

Although traditional risk profiling measures tend to categorise most clients as having sufficient risk tolerance to cope with an exposure to potentially volatile growth assets such as Australian shares, the data shows overwhelmingly that at the most critical of times – when markets are falling, the average investor’s tolerance for risk is in fact far lower than they thought! The result is that in far too many cases, investors exit the market at exactly the wrong time, causing horrendous damage to their long-term returns.

Our Bellmont Buy-Write Portfolio helps to mitigate this effect by providing equity market exposure, complete with dividends and franking credits, but with substantially lower downside risk as a result of our conservative derivative hedging strategy. Given these findings, it may well be that the biggest benefit of this strategy is not that it should outperform over the market cycle (which it should) – but that it may well increase the likelihood that the investor will in fact be invested for the entire cycle!

A full copy of the DALBAR study is available for download by clicking here.

If you would like to find out more about Bellmont’s share portfolios, please click here.

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