Over the past 20 years the average equity fund investor has achieved a return significantly below that of the benchmark, according to new research from US firm Dalbar. The poor performance was not due to poor manager selection, but rather due to investor behaviour.
To understand the research, let?s go back to 1985. This was the year the first AM station started broadcasting in Australia, Mikhail Gorbachev was elected leader of the Soviet Union and the first dotcom name was registered. Two investors ? James and Mark ? inherited US$10,000 each, which they both decided to invest into the same US equity fund.
James and Mark adopted two different strategies for management of their investments. James regularly followed how his US$10,000 investments tracked against peer funds, and let emotion drive his decision-making. Mark was less sensitive than James to short-term volatility and was happy to adopt a set-and-forget strategy.
In 1986, both James? and Mark?s investment was worth US$12,000 after a strong rise in equity markets. In the wake of the 1987 October crash, the value of their portfolios declined to US$9,600. James feared this marked the beginning of a bear market and switched half of the investment to a fixed interest portfolio and encouraged Mark to do the same. Mark stuck to his guns and left the money in the same fund. By August 1988, James? account was worth US$12,300, while Mark?s investment was valued at US$15,000.
Over the next 18 years, James continued switching between shares and fixed interest as the market ebbed and flowed.
By the end of December 2005, James? portfolio had increased to US$21,422. Mark meanwhile had amassed US$94,555.
Which person more accurately reflects the behaviour of the average managed fund investor? You guessed it ? James.
Over the 20 years to the end of December 2005, the average US equity fund investor achieved an annual return of 3.9 per cent. This return was 8 per cent lower than the annual return of the benchmark S&P 500 (11.9 per cent a year). The lower return was the result of the average investor trying to time investment in the equity market by tactically allocating between fixed interest and shares.
Even if an investor selected a bottom quartile manager they still would have significantly beaten the return of the average equity fund investor (James), who sought to time his allocation between fixed interest and shares.
The Dalbar analysis shows investor behaviour not fund selection is the most important factor in determining return.
Why are investors so poor at timing their allocation to equities?
The answer lies in behavioural finance. Investors underperform because they are motivated by greed and fear. Dalbar?s research shows investors tend to invest at the top of the market and exit at the bottom.
Investor flows to markets were strongest during rising markets (1992, 1995, 1996, 1997 and 2002) and weakest during downturns (1988, 1989 and 2002).
The growth of sector-specific funds in the late 1990s was fuelled by investors chasing historical returns. Similar waves of optimism are fuelling demand for emerging market, resource and regional Asian equity exposure today.
The challenge for advisers is to manage this investor behaviour.
Investors tend to give greater weight to the current waves of sentiment than to long-term investment prospects. Advisers should highlight to clients that during periods when negative sentiment drives the market this potentially creates an opportunity for new investment rather than the impetus for a quick exit.
A look at the US market indicates it has moved up 60 per cent of the time and down only 40 per cent for each month of the past 20 years. This is why it makes sense for growth-oriented investors to retain exposure to equities over the long term. Given investors are poor at tactically allocating assets, passive strategic allocations are the most sensible way to generate a return.
Financial advisers will play an important role in framing investors expectations not only with reference to their objectives but also against the market.
