If I had invested $10,000 into large-capitalization U.S. stocks in January 1926, I would have a portfolio worth $60,351,158 at the end of 2016. Very impressive. This represents an annualized return of 10.04%. Of course, an unfortunate reality that would have prevented me from becoming a multi-millionaire in this way is that I was even not born in 1926; I could not have made this investment. Let's keep the example as simple as possible and suppose that based on when I was alive and working, I was instead able to invest $10,000 into large-capitalization U.S. stocks in January 1995. This investment would have grown to $75,423 by the end of 2016. From the perspective of the 1926 starting point, the growth of my $10,000 to $75,423 represents an annualized return of 2.25%. The market earned an annualized 10.04%, but I only earned 2.25%. I underperformed the market by 7.79% on an annualized basis. My investor return did not match the market's investment return. I didn't enter the market at the right time. How unfortunate for me.
Does the conclusion made in the previous paragraph make sense to you? I posit that this conclusion would strike most as illogical, especially if it was followed by a lecture about my poor investing behavior because I sat out of the market in the years before 1995.
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Unfortunately, the conclusion reached in the first paragraph is only a slightly exaggerated version of the basis for why the annual "Quantitative Analysis of Investor Behavior" study by DALBAR concludes that investor returns fall short of investment returns. Their report is widely lauded by the financial services industry as demonstration about how investors perform poorly. Over different periods of time, they compare the total wealth accumulated if an entire investment was made at the beginning of the time period to the total wealth accumulated based on inflows and outflows of investor funds over time. Because markets tend to rise on average, it is very difficult for an investor gradually adding funds over time to do better than having an entire lump-sum investment made at the beginning of the time period. Their funds don't have as much opportunity to grow. So the study concludes that investor returns lag investment returns.
For instance, in their 2016 study they investigated the 20-year period through the end of 2015. They report that the S&P 500 earned an annualized return of 8.19% over this time frame. But from the perspective of the average equity mutual fund investor, the annualized returns from the start of the 20-year period only amounted to 4.67%. They report that investors lagged the market by an annualized 3.52%. They attribute this underperformance to four factors: the lack of cash to invest accounts for 0.54%, the need for cash accounts for 0.68%, fund expenses account for 0.79%, and voluntary poor behaviors account for 1.5%. The study does not clarify how these numbers were calculated, but it identifies poor behavior as the most important factor.
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We need to take a step back. Wouldn't it make more sense to calculate annualized returns based on the period I was actually able to invest? For that earlier simple example, the growth to $75,423 represents an annualized return of 9.62% since the start of 1995. This is still a bit less than 10.04%, but that is not because of poor investing behavior on my part. It was just that market returns were less in this more recent period. And that underperformance relative to a 1926 start date can be fully explained by a lack of cash to invest. Voluntary poor behavior had nothing to do with it.
There are two ways that DALBAR could improve its study so that the results were more meaningful in terms of actually identifying voluntary poor behavior. One option is to calculate an internal rate of return using the investor cash flows. That would at least provide a number that is comparable to the accumulated wealth derived by making the full investment at the start of the time period. In the case of the simple example, this would mean comparing 10.04% to 9.62%, not to 2.25%.
The other alternative would be to change the benchmark for comparison to a systematic investor that automatically invests the same amount into the market each month without concern for recent market movements. With this benchmark, if the investor's accumulated wealth based on actual cash inflows outflows was less than the systematic investor, then we could conclude that voluntary poor behavior may be a culprit for any underperformance. Actually, for that 20-year period ending in 2015, DALBAR did report the result for a systematic investor: It was an annualized 3.99%, falling short of the investor return of 4.67%. The systematic investor accumulated $21,884 while the average investor accumulated $24,894. In this regard, the average investor outperformed a systematic strategy during this time period. That sounds like good timing decisions were made in the aggregate, not poor decisions.
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As it stands, the way the DALBAR study presents its results unfairly compares wealth accumulations by making a lump-sum investment at the beginning against making ongoing inflows and outflows over time. Real world accumulators do not get the benefit of being full invested over the full time period. They add new contributions when they can. The DALBAR methodology seeks to identify voluntary poor performance as being the primary cause when their calculation method mostly just reveals a lack of available cash to invest.
Wade D. Pfau is a professor of retirement income in the Ph.D. program in financial services and retirement planning at The American College.
