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Are Investors That Bad?

Published on: Mar 10 2017

You might be familiar with the annual study from the firm DALBAR. You almost certainly have heard of the study if you receive communications from a brokerage firm or investment advisor. In a nutshell, the study compares the returns of buying and holding investments with the returns based on flows in and out of the investments. The result is that the actual returns of the average investor, estimated using the cash flows, are far lower than the buy and hold returns. That’s because investors tend to buy after prices have increased and sell after they’ve declined.

The study is not without its critics. This article questions a lot of the math in the study and also refers readers to two other papers that criticize DALBAR’s methods. The article also has a response from the head of DALBAR at the end. The article is a little focused on the math and not for everyone. But its main point is that not everyone agrees with DALBAR’s methodology.

Sit properly demonstrated the point that the market index is based on time-weighted returns (assuming the investment of a lump-sum amount at the start of the period), while investors with ongoing savings and distribution needs will experience a different money-weighted return. With ongoing contributions to investments over time, an investor will underperform the market index if returns tend to be relatively higher in the early part of the investment period when less is invested, and lower in the latter part of the investment period when more funds are invested.

That is a very important point, but it is only part of the story of what the DALBAR study is getting wrong. A key point from Sit’s article that led me on this journey was his reference to how the DALBAR study also shows results for a dollar-cost averaging investor. I’ll come back to this shortly.

The other critical piece I have found about the DALBAR study is an excerpt from the book, The Three Simple Rules of Investing: Why Everything You’ve Heard about Investing is Wrong – And What to Do Instead, by Michael Edesess, Kwok L. Tsui, Carol Fabbri, and George Peacock. That excerpt is posted here at Advisor Perspectives. The authors cited Sit’s analysis (incorrectly attributed to Kitces) about the confusion of money-weighted and time-weighted returns. They also made a new, relevant point about how if mutual fund investors (which includes many professional investors) are underperforming the market so dramatically, then who exactly is on the other side of these trades to outperform by so much? This remains as an unsolved mystery.

 

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