How Investors Miss Big Profits
by Louis Harvey
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.
In this article
- Buying High and Selling Low
- Reasons for the Irrational Behavior
- Use, Instead of Fighting, Psychological Behaviors
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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.
I developed a calculation that would measure whether mutual fund investors were actually earning more or less than the reported alpha. In 1994, DALBAR issued the first Quantitative Analysis of Investor Behavior (QAIB), showing that investors had severely underperformed the average mutual fund alpha! This underperformance continues to this day.
Investors were actually missing much of the alpha that mutual funds had earned. Using the S&P 500 index to approximate the returns that equity mutual funds produced, investors were leaving between 10.97% and 4.32% on the table, as Table 1 shows.
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Discussion
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.
posted 5 months ago by Owen Newcomer from California
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.
posted 5 months ago by Bob Stein from Ohio
sensible, but complex, especially for an average investor. Allocation and re-balancing seem equally effective.
posted 5 months ago by Edward Spitzer from Pennsylvania
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.
posted 5 months ago by William Orlowski from Wisconsin
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.
posted 5 months ago by Kim Bedell from North Carolina
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.
posted 4 months ago by Richard Ballew from California
"...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.
posted 4 months ago by Maureen Gill from New Jersey
What happened to the comment that I posted yesterday??
posted 4 months ago by Thomas Keon from Pennsylvania
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.
posted 4 months ago by Robert Carr from New York
