The research firm DALBAR has been studying the behaviour of mutual fund investors for 25 years. Each year the firm reports how poorly investors fared relative to their benchmark index over time. What the data repeatedly shows is a ‘behaviour gap‘ that leads to significant investor underperformance.
It suggests that investors lack the patience to stay invested in any one fund for longer than four years. Furthermore, investors make ill-timed choices, invariably chasing last year’s winners while dumping what they perceive to be underperforming funds.
Why are investment returns so bad?
The chart below shows the annualized returns for equity mutual fund investors compared to the S&P 500 over 1, 10, and 30 year periods.
|Equity mutual fund investors||S&P 500||Difference|
Now, I’m the first to rail against the mutual fund industry for charging high fees and failing to protect investors from unscrupulous advisors. Those practices do lead to poorer returns and do nothing to help investors achieve better outcomes. But studies like this show that investors are mostly their own worst enemy.
I also thought the panacea for investors was indexing. Just dump your high-fee mutual funds and switch to a low fee, globally diversified portfolio of index funds or ETFs. Make regular contributions, but otherwise leave it alone for your entire investing horizon. Problem solved.
But clearly that’s not working, either. Investors, even passive ones, are constantly looking to fine-tune their portfolio and tinker with what should be a good-enough solution.
We have access to more information than ever before, including the ability to trade on that information. What we really need is the ability to lock up our long-term investments in a way that prevents us from doing something we’ll regret.
Intuitively, DALBAR suggested that the much maligned variable rate annuity (a high-fee insurance product sold in the U.S.) acted in such a way that investors in variable annuities outperformed mutual fund investors, despite the higher fees.
An all GIC solution?
DALBAR’s odd solution reminded me of an article I wrote more than six years ago about using an all GIC portfolio. This controversial savings strategy was popularized by accountant and author David Trahair.
He suggested that most Canadians were better off forgoing any investing until their mortgage was paid off. Once mortgage-free, Trahair says to ramp up your savings rate but avoid the market and stick to ultra-safe GICs.
The downside of an all GIC approach is inflation – if you’re just treading water at 2-3 percent then you’re going to need to save a lot more money than if you were potentially earning 6-8 percent in the market.
The idea seems counterintuitive until you look at the data. Actual investor returns underperform so badly that some of us would be better off avoiding market and behaviour risk altogether and opting for the guaranteed return.
It’s a strange concept, especially for readers of this blog. After all, my own portfolio is made up of 100 percent equities and I preach staying the course with a long-term index investing strategy.
But is it that strange for the vast majority of investors? You know, the ones making these egregious behavioural errors and constantly shooting themselves in the foot? How many are actually making themselves poorer simply by trying to invest?
A behavioural problem
I often write about credit card rewards and the first rule of earning rewards is that you pay off your balance on time and in full, without fail. It’s such obvious advice that it often goes unsaid. It’s foolish to try to earn 2 percent back on your spending if you’re paying 19 percent interest on an unpaid balance.
Yet Canadians carry an average credit card balance of $4,154. We’re obviously not getting the message when it comes to controlling our behaviour.
Investing seems to be no different. We all know to buy low and sell high. Yet the studies show we’re doing the opposite. We all know to ignore the pundits and headlines – it’s the long-term that matters most. But, again, we can’t help checking our portfolio balance during a market meltdown. Worse, we make changes to a perfectly sensible portfolio based on useless economic predictions that rarely come to pass.
So, what to do when investments returns are so bad they make GIC returns look good? Switch to an all GIC portfolio? Nah. Not for intelligent blog readers like yourselves.
Reports like this are a good reminder to make sure you have an investment policy statement – the ten commandments, if you will, that guide your future investment behaviour. A few, thou shall nots, should suffice.
As perverted as it sounds, the mutual fund industry will use this study to preach the benefits of deferred sales charge (DSC) mutual funds that lock-in investors for a period of 5-7 years with high redemption penalties. I don’t buy it.
My takeaway from the DALBAR report is that advisors need to focus less on selling investments and spend more time on financial planning. Investors with an appropriate portfolio don’t need to hear about the latest hot sector or region in which to invest. The very idea is counter to a long-term, globally diversified approach.
Accept market returns, minus a small fee, and get to work on improving other aspects of your finances, such as retirement planning, estate planning, assessing your insurance needs, and increasing your savings rate.
You’ll improve your investment returns simply by leaving your portfolio alone.