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 Forget
what the college economics textbooks teach you -- individuals
are emotional and irrational.
Sure, in the theoretical Guns and Butter (or, for the hip new-school textbooks
which try to build "street cred" with students: Beer and Pizza)
world, there's a rational trade-off, supported by thoroughly structured
and emotionally detached reasoning and rationale. But in our world, which
we'll refer to as "reality", there is one additional
and important variable to add to the equation: Emotion. And one additional
and important variable to subtract from the equation: Rationality.
One common thread amongst humans is our ability to rationalize our actions,
despite the known consequences that are derived from the decision. Children,
for instance, subversively rationalize against turning off the lights,
making their beds, shutting the refrigerator door, doing their homework,
and taking their shoes off before they enter the house. They know (at least
subconsciously) under each circumstance that there is a penalty for doing -- or
not doing -- each of these actions, yet still they choose to proceed.
As we age, the specific behaviors may change (think back to your college
days, for example), but the premise remains. Today we've all gotten
much better in turning off the lights and shutting the refrigerator door
(amazing what happens when you have to pay the bills!), yet the data is
overwhelming that within the realm of one of the more significant and impactful
decisions we make in our lifetimes -- specifically the act of saving
and investing for retirement -- we humans, as "investors",
have yet to assemble the requisite habits, characteristics, and behaviors
to do so successfully.
The irrational line of thought which espouses an individual's "rational
behavior" has also managed to extend itself into the world of investing.
And guess what -- irrationality is costing investors money. So let's
analyze how irrational and emotionally influenced behaviors are detrimentally
affecting the performance and outcome of retirement savings.
There are many means by which to demonstrate this faulty behavior -- an
investor who chases performance, one whose portfolio is not properly balanced
and diversified, one whose portfolio
is overly concentrated, or an elderly
couple nearing retirement whose
savings
are 100% in stocks.
Yet, if there's one data point that fully and completely captures
each of these subliminal mistakes as listed above, and which aggregates
the result into a measurable output, it would be the actual returns that
individual investors are achieving on their investments. Regretfully, there's
a difference between an investor's actual return, and the return
of the product or vehicle in which that individual is invested.
To more intensely examine this concept, we'll be utilizing the Morningstar
Investor Return data series to illustrate our findings, which states:
"Investor's return measures the experience of the average
investor in a (mutual) fund. It is not one specific investor's
experience, but rather a measure of the return earned collectively by
all the investors in the fund. Investor returns are not a substitute
for total returns but can be used in combination with total returns."
Just looking at how your mutual fund performed over the one, three and
five year or more periods is probably not the best way to gauge what your
actual performance was. The impact of cash contributions and withdrawals
would have varying degrees of impact on your actual performance depending
on the size (as a percentage of your original position) and timing of the
said contribution or withdrawal. Regretfully for most of us, it is emotion
that drives the timing of those contributions, and usually it is to the
detriment of performance.
The concept of emotionally and momentum driven investment decision making
takes a more interesting turn when you begin introducing the above mentioned
Morningstar Investor Return numbers. Here, the introduction of differing
asset classes as well as sector, style, regional and thematically focused
mutual funds provide telling insight into most individual's inability
to achieve and maintain a systematic and disciplined approach to the investment
process.
In developing this study, our goal was to estimate how the average investor
had performed over a five year period, compared to how that same investment
vehicle (mutual fund returns, net of fees) performed over the same time
frame. These actual and investor returns have been asset weighted using
the fund's July 31st, 2008 share-class net assets, in relation to
the size of the comparable universe. We concede that, ideally, this study
would take into account the change in each individual fund's sizes
over these time frames -- but for simplicity's sake, knowing
the general theme and story would remain, we've chosen to use the
most recent month's data.
Underperforming Your Own Investments: Not only possible, but probable
First,
let's look at how the investors of actively managed mutual
funds have fared over five years. As is illustrated below, investors
on average have underperformed by anywhere from 1.00% to over 3.00% on
an annualized basis over five years!
Additionally, the second chart shows how individual investors of Index
Funds have performed over the same time periods. As some individuals have
elected to disdain the concept of active management, the data below shows
that even index investors consistently fail to achieve the returns of the
indices that they're invested in, despite some studies that have
demonstrated the underperformance of actively managed mutual funds relative
to the indices.
One of the more interesting aspects of this study is of how it renders
the Active vs. Passive investment approach debate irrelevant. The purpose
of this study is not to promote or discredit either theory -- but
instead to provide hard evidence on the actual experience of the average
investor who chooses either path.
From a different perspective, lets take a look at how many individual
fund investors actually perform in-line, or better than, the fund that
they're invested in. This is depicted in the following chart showing
different categories of index and actively managed funds on an equal weighted/average
basis, and the results aren't pretty.
As shown, only slightly more than 50% of equity index and actively managed
fund investors have performed at least in line with the underlying funds.
The same can't be said for internationally mandated funds, as those
investors have experienced worse performance than the funds themselves
over 70% of the time for index funds, and over 60% of the time for actively
managed funds.
Fixed income fund investors have, likewise, experienced an inferior performance
over 50% of the time.
So while many people are often asking themselves: "If I make an
investment in this fund, will I beat the market?" The real question
they should be asking is: "If I make an investment in this fund,
will I perform in-line with the fund itself?" Sadly, the answer
to both iterations of the above question is a resounding, "No!"
The Hidden Cost: What you don't see, is delaying
your retirement
So
how would this directly affect your portfolio's performance?
We took a hypothetical 80/20 split between US Equity and International
Mutual Funds (a composition which is generously conservative, given the
data we've compiled on international allocations of the average retail
investor over the past decade). We captured a loss of over $11,000 over
the five year period due to investor behavior and emotion!
The bottom line is that prior to making your next sizable contribution
to a mutual fund, does knowing that you have a 50/50 or less chance of
achieving the actual returns of that fund over the next three or five
years make you second guess that decision? Are you chasing performance
into a fund or sector that may be near the end of its run? Are you only
now rebalancing or cutting back on exposure from your natural resource
and international funds, or have you "doubled-down" now that
they've pulled back in recent months? Those are just some of the
irrational and emotion driven investing mistakes that drive the discouraging
data points illustrated in this piece.
As a small aside, and seeing as I've recently become a proud new
father to a Weimaraner puppy (Winston), the top two items typically on
my mind tend to be the markets, and Winston. It struck me the other week when I took him to his first obedience training course, when the instructor
said, "Only 20% of this obedience class is actually geared towards
training the puppy. The other 80% is training the owner on how to properly
manage and handle the dog."
I believe, and this data supports, that far too often we see the market
through this faulty logic, whereas it isn't us but the markets that
need to be "corrected" to conform to our wishes and demands.
Instead of educating our emotional sensibilities, realigning our expectations,
and adhering or outsourcing to a systematic investment process, we expect
the markets to change to suit our ways.
Now if I could just decide what I want to train my dog to fetch for me -- beer,
or pizza. Would it be irrational to expect both?
-- Bryan Keller, Research Analyst
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