Psychological factors behind investor losses

Published April 14, 2012
INVESTING

Dalbar study of investor behaviour shows that the 'average investor' underperforms benchmarks due to his tendency to buy high and sell low

By Genevieve Cua Personal Finance Editor

How they stack VOLATILITY in 2011 has thrown into sharp relief the damage that investor fear and greed wreak, says Dalbar's latest Quantitative Analysis of Investor Behaviour (QAIB).

The study shows - as it has for the last 17 years since it began to track investor behaviour - that the "average investor" underperforms common benchmarks due to his tendency to buy high and sell low at the worst moments.

Using data from the Investment Company Institute, Standard & Poor's and Barclays Capital Index Products, the firm has found that the average equity mutual fund investor lost 5.73 per cent in 2011, compared to the S&P 500's gain of 2.12 per cent. This is a negative differential of more than seven percentage points.

To illustrate investors' poor timing, the month of September saw a large uptick in the S&P 500. But that was a month when fund flows were close to zero. However, fund flows rose to 10 per cent of total assets two months later. By that time the S&P 500 had lost nearly half its gains.

The average fixed income investor saw a positive return of 1.34 per cent, but this was significantly below the Treasury yield. The Barclays Aggregate Bond Index's return was 7.84 per cent.

Dalbar believes nine psychological factors of behavioural finance cause investors' underperformance over the long and short term. These are:

• Loss aversion or the expectation of high returns with low risk;
• Narrow framing, where decisions are made without considering all implications;
• Anchoring which links situations to familiar experience, even though this is inappropriate;
• Mental accounting which takes undue risk in one area and avoids rational risk in others;
• Diversification which seeks to reduce risk but by simply using different sources;
• Herding or copying the behaviour of others;
• Regret
• Media response or reacting to news;
• Optimism or the belief that good things happen to the investor and bad things happen to others.

Dalbar says volatility set new records in 2011 and in the United States, this was accompanied by regulatory flip-flops.

"Records were set for both up and down days. As dramatic as it has been, the market was not the only area of volatility. Starting with the 'certainty' of a Dodd-Frank universal fiduciary standard that fizzled in dissension at the SEC, we saw a series of regulatory initiatives threaten and then fall by the wayside.

"Even more significant than the uncertainties of 2011 is the fact that the causes of the upheaval remain unchanged, making it likely that this volatility in markets and regulation could become a new norm."

Dalbar adds that the dramatic swings in the market feed investors' fear and greed, causing them to abandon their investment strategy and sell out of the funds they own. "This is sometimes due to fear but other times due to the investor's temptation to time the market. These and other irrational behaviours can lead to devastating investment results."

The QAIB reflects investor behaviour using ICI data on fund sales, redemption and exchanges; it takes the net dollar volume of these activities monthly. Investor returns are calculated as the change in assets, after excluding sales, redemptions and exchanges. The calculation captures realised and unrealised capital gains, interest, dividends, trading costs and other cost items such as sales charges and fees.

Dalbar data shows that both equity and fixed income mutual fund investors underperformed the market over one, three, five, 10 and 20-year periods.

The average asset allocation or balanced investor outperformed equity investors in 2011 with a negative return of minus 1.27 per cent. This is only the sixth time that asset allocation investors have outperformed over the last 20 years.

On a 20-year basis, the average equity investor underperformed the S&P 500 by 4.32 per cent on an annualised basis. The average annualised underperformance of the fixed income investor against the Barclays Aggregate Bond Index is 5.56 per cent. Interestingly the performance gap between the equity investor and the S&P 500 has actually narrowed over the years. In 1997, for instance, the gap was over 10 percentage points.

"It is believed that the improving results from 1997 to 2011 were largely due to the fact that investors who entered the market in the '90s have now experienced multiple market declines and recoveries, and have learned from those experiences. They found that remaining invested has, over the long term, produced positive results."

Still, the study also found that remaining invested is a challenge. "One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets."

The average equity mutual fund retention rate is about 3.29 years; fixed income 3.09 years and asset allocation 4.42 years.

The average fixed income and asset allocation investors generally failed to keep pace with inflation based on 20, 10, five and one-year periods. Equity investors beat inflation on a 20-year and three-year periods, but failed to do so on 10, five and one-year periods.

QAIB also looks into systematic investing where a hypothetical US$10,000 is evenly distributed across each month. It found that for 2011, the average equity investor earned US$9,853 compared to a systematic investor's earnings of US$8,665. It said this underperformance of the systematic equity investor does not mean that the method of investing should be abandoned. "It should, however, cause investors or their financial advisers to seek new strategies to counteract investor behaviour that loses alpha."

The average systematic fixed income investor overwhelmingly outperformed the average fixed income investor over a 20-year period, earning four times as much. - BT