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How Investors Miss Big Profits

by Louis Harvey

How Investors Miss Big Profits Splash image

Back in 1993, a curious thought crossed my mind while analyzing the federal regulations that were new at the time.

Mutual funds were permitted to report investment returns for one, three, five and 10 years (“alpha”), but how many investors actually kept their investments unchanged for those specific periods? If all investors did not hold on to their investments for those precise periods, then they had to be doing better or worse than was being reported.

Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index is a fund’s alpha. Simply stated, alpha represents the value that a portfolio manager adds to or subtracts from a fund’s return. Investors’ alpha is the value a retail investor adds to or subtracts from the alpha delivered by the portfolio manager. The return of the respective index is considered to be zero alpha, so any excess over the index is considered positive investor alpha.

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Louis Harvey is the president of DALBAR Inc., the financial community’s leading independent expert for evaluating, auditing and rating business practices, customer performance, product quality and service.


Discussion

Owen Newcomer from California posted about 1 year ago:

While Harvey's approach will work, it seems overly complex. How is Harvey's approach better or easier than using the tradition fixed asset allocation targets, and rebalancing as appropriate. Using the traditional asset allocation approach, I will buy low and sell high so as to rebalance. All I need is to decide how far off of the chosen target allocations warrant rebalancing. Of course, the hard part is actually doing the rebalancing. But is this any more difficult psychologically than Harvey's approach? I'll vote for the traditional approach.


Bob Stein from Ohio posted about 1 year ago:

I am on the board of a major state pension fund. We have found this underperformance to be true for people who run their own investments in our DC plans. The DB pension plan also does much better because of the pooled longevity risk. A pension plan never gets old so it can keep a "young" asset allocation forever.


Edward Spitzer from Pennsylvania posted about 1 year ago:

sensible, but complex, especially for an average investor. Allocation and re-balancing seem equally effective.


William Orlowski from Wisconsin posted about 1 year ago:

Your article is very valuable for the average or novice investor. Loss aversion is common for these investors, since most of them lost money in the years 2000-2002 as well as late 2007 to March,2009. However, simply buying Index funds in 2000 and holding them through 2010 did not work either(i.e.,the Lost Decade). Unfortunately, most mutual fund managers have not proven to outperform the ETF indexes such as the SPX,RUT, QQQ, DIA, etc. over this same period.


Kim Bedell from North Carolina posted about 1 year ago:

Great article. We are in it for the long haul, and put as much extra money in as we can during down times. It wasn't always like that though. Years ago, we stopped putting in during a down time. After the fact, I went back and figured out how much further we would have been ahead, had we continued our monthly investing....it was amazing and shocking to see the results.


Richard Ballew from California posted about 1 year ago:

Your findings in the area of behavioral finance are quite clear, and I think few professionals would challenge it, however I want to raise one issue of PBAM I have witnessed over the years. In the context of a rational discussion the approach makes good sense and may indeed generate a high rate of acceptance by investors. However, if the circumstance of the investor in the context of PBAM results in an aggregate asset allocation quite different from the investor's risk profile (most likely toward the conservative side) or in contrast with market conditions, it can cause investor frustration (regret) that sabotages the process. I am curious what you have found in your own experience.


Maureen Gill from New Jersey posted about 1 year ago:

"...mutual fund investors were selling investments long after the large institutions had taken their profits"

Simply put, the retail investors got clipped -- yet again -- by the professionals.


Thomas Keon from Pennsylvania posted about 1 year ago:

What happened to the comment that I posted yesterday??


Robert Carr from New York posted about 1 year ago:

When you reinvest dividends as you receive them, the down markets are a gift that allow you to accumulate more shares at low prices. This phenomenon magnifies compound interest assuming the price is down due to market pressure and not that there is something wrong with the business.


Robert Anderson from California posted 9 months ago:

Although the concept of allocating funds to different end purposes seems reassuring, the best investment returns are either in growth stocks or small cap value funds. Keeping other funds in low yield "safe" investments should be limited to cash essential to have for required living expenses. Otherwise, wealth accumulation will be undermined. The difference between a correction and a bear market must be evaluated by charting. Selling to avoid ruinous losses makes sense in a bear market. Riding down 50% or more is failure to preserve capital, but selling during every 10% correction is ill advised. Buy and sell "do nothing" seems as foolish as panic selling in every decline.


Stephen from Florida posted 9 months ago:

Robert from California:
If only it worked the way you describe it. If one easily knew when we were in a bear market or a correction then very few would lose money. An investor would have to know if they are in a bear or a correction, but it is only after the fact that one knows that. If you get out when it is down 20%, which is a bear market, then you have to know when to get back in as well. Making 2 right decisions all the time is very tough. Even the greats acknowledge it can not be done. Buffett says he only knows of market peaks or troughs well after they happen.
You suggest using charts. Buffett and Peter Lynch both say of charts:
" a chart only tells you what happened in the past" and " if you turn a chart upside down it looks the same".


Douglas Johnson from Texas posted 9 months ago:

Yeah, Robert, by the time you know you are in a bear market, it is too late to sell. You've found yourself on a roller coaster. The only thing to do is ride it down and back up. You fail to preserve capital only if you sell.
-- Doug


Charles Comereski from New York posted 9 months ago:

What about using stop losses to protect on the down side..?


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