Investor behavior. . . or Advisor behavior?

Every year the Dalbar Quantitative Analysis of Investor Behavior (QAIB) is released, showing the results of the financial research firm's examination of investor behavior a twenty-year period beginning in 1987. The results for 2007 are not in yet (that QAIB, which will be called the 2008 QAIB, will come out in March or April 2008), but the 2007 QAIB shows results for the 20-year period stretching from the beginning of 1987 through the end of 2006.

As in previous years, the study's results have shown that "the average investor earned significantly less than mutual fund performance reports would suggest," according to the study. The reports have consistently demonstrated that over time, investors underperform the actual investment vehicles available to them. The study found that the average annualized return over the twenty year period was only 4.3% (the overall market had an annualized return of 11.8% over the same twenty year period). Dalbar's analysis argues that it is erratic investor behavior, rather than the funds selected, that causes this tremendous performance erosion over time.

Dalbar's examination of the data for the entire mutual fund industry over a long period of time reveals that the tendency to rush in when the market is going up and rush out when the market is going down reduces investor returns to a fraction of what they would have made if they invested consistently over the same long period. The study found that "investors make most mistakes after down turns" and suggested that "These mistakes occur because investors are driven by the fear that the markets will not recover -- even though broad indices show that markets do indeed recover."

The study provides a variety of data that shows that it is not the investment vehicle that is the problem, but rather the investor behavior. It suggests that professional advisors can help with this behavioral problem.

BUT the Dalbar data does not differentiate between investors who have a professional advisor and those who do not!

Dalbar uses equity mutual fund data from the Investment Company Institute, which tracks a variety of data concerning the mutual fund industry .

A review of the 2007 ICI Fact Book reveals that ICI states that "ICI research finds that approximately 80 percent of mutual fund investors seek professional advice when buying mutual fund shares outside of retirement plans at work" (Section 5 -- 12b1 fees).

This suggests that a significant percentage of the mutual fund investors who are following damaging investment patterns discussed in the annual Dalbar surveys have professional advisors!

Our experience suggests that the heart of this problem lies in the fact that the vast majority of advisors today (whether they are at a big brokerage firm or a tiny independent shop on Main Street) are basically "selectors of other managers." In other words, they are in the business of selecting mutual funds or other managed vehicles for their clients.

Because of the divide between those who actually manage the money and those who advise clients (see this previous post on the subject), advisors can show performance records that go back many years but which none of their clients were in during those many years. In other words, they can have the same kind of "rear-view mirror" selection of investment vehicles that causes the results found in the Dalbar studies every year.

When an advisor holds up the performance record of a potential investment vehicle to a client (whether the vehicle is a mutual fund, an index fund, a separately managed portfolio, or something else), very few clients ever ask "I see how that investment has performed, but how long have your assets and your clients' assets been in that vehicle?"

In other words, the track record that you see on any managed portfolio (or an index fund or ETF) only represents a potential return. Actual returns have been shown to be significantly lower among the population that shops around (erratically) among all those potential investment vehicles.

Because the vast majority of advisors do not manage their clients' assets themselves, but instead select other managers (or index funds) to manage their clients' assets, could it be that they are as prone to switching vehicles as anyone else?

The actual portfolio managers who invest in their own portfolios ("eat their own cooking") year after year will receive those actual portfolio returns (their actual returns will be the same as the "potential returns"), but advisors and other investors who switch in and out of those portfolios (studies consistently find) achieve only a fraction of the potential return.

It is interesting to note that this is probably a fairly modern phenomenon, coinciding with the rise of the mutual fund industry and the "outsourcing" of money management. The period covered by the Dalbar studies is the same period in which this outsourcing of money management grew astronomically.

It's easy to forget that prior to the advent of the internet, the ordinary person could see stock quotations only once a day, in the morning paper. If he wanted more information, he could call a broker for a quote, or go down to a local brokerage branch office and "watch the tape" in the lobby. Back then, brokers truly had access to more information than the average investor.

The advent of the internet changed the entire model. Today, the old-school "broker" is a thing of the past. He has been replaced with the "financial advisor" who no longer "picks stocks" for his clients but instead picks managers. The fear in the brokerage days was that there might be unscrupulous brokers who "churned" their clients' accounts for commissions. But, since the advisor typically works for some kind of annual fee (often some portion of the fee stream paid to the mutual funds or other managers he selects for his clients), the danger is that the advisor will change managers more frequently than he should, both because he can fall into the same performance-chasing traps that the annual Dalbar surveys discuss, and in order to justify his existence as the "picker" of good managers.

This is not an "investment vehicle problem" -- the solution is not to say "Oh, that means you should buy index funds, or ETFs, or SMAs, instead of mutual funds." This is a financial industry problem. Mutual fund managers and other professional managers are vitally important to investors -- it is the "advisor" system that has grown up after the era of the broker that may be the problem. We would argue that the data in fourteen Dalbar surveys argues strongly that something is wrong not just with individual investors, but with the rise of advisors whose job is basically to "pick managers."

for later blog posts dealing with this same subject, see also:

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1 comment:

  1. I have always wondered how they advisers pick the stocks and what the basis of their annual returns are. When I looked at the industry's long term charts and their charts, there seems to be no difference, but a few differences here and there. I wonder what historical data they use most of the time to come up with those charts. With the current mayhem in the market, what is the performance of mutual funds or other investment vehicles?