Are Individual Investors Destined to Fail?

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Individual Investor

By Chris Gay

It's axiomatic among financial-service professionals that most do-it-yourself investors are their own worst enemies, always in the grip of some cognitive bias or other leading inexorably toward the worst possible investment decision.

Or are the professionals too pessimistic? True, there is a long history of self-directed investors generally underperforming and sometimes going up in smoke. But there is also recent evidence that, while most of us still do worse than the funds we invest in, we're collectively closing the gap and managing to tame certain value-destroying reptilian impulses.

A Vanguard study released this month, for example, challenges the notion that the rise of the exchange-traded fund-which investors can trade at will, like a stock-would create a culture of day traders who'd throw long-termism to the winds and gamble away their savings. Enthralled by the "ETF temptation effect," the theory went, a self-selected group of active investors would gravitate to ETFs, where they'd chase past performance, run up transaction costs and generally behave like reverse indicators on autopilot.

"ETFs introduce a different type of investor that doesn't exist on the mutual-fund side, and that's the day trader," says Lou Harvey, president of Dalbar, Inc., a Boston analytical firm whose annual "Quantitative Analysis of Investor Behavior" (QAIB) documents the wayward performance of individual investors.

For all that, the Vanguard report ("ETFs: For the better or bettor?") argues that such funds are not weapons of self-destruction, after all. "In general, both ETF and traditional mutual fund shareholders proved to be long-term, buy-and-hold investors," it concludes. The study is based on 3.2 million transactions in more than half a million accounts held in various Vanguard mutual funds and ETFs over four years through 2011.

Some key findings: 62 percent of ETF accounts fell into the buy-and-hold category, which Vanguard defines as an investment held for more than a year and experiencing no more than two investment "reversals" (the first sell after a buy, or vice-versa) in any rolling one-year period. That's lower than the 83 percent scored for mutual-fund holders, but still evidence, says Vanguard, that the temptation to trade is not the threat it was cracked up to be "and is not a significant reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio."

While trading behavior of ETF holders was more active than that of those in mutual funds-27 percent of ETF positions were held short-term, compared with 12 percent for mutual funds-"more than 40% of the variation can be explained simply by correcting for differences in personal and account characteristics between ETF and traditional fund shareholders," reported Vanguard. The temptation effect does explain part of the other 60 percent, the study concedes, though Vanguard's own limits on trading mutual funds, as well as unknowable self-selection effects whose impacts are indeterminate, also matter.

"Sure Thing" Investing Theories Put to the Test
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Are Individual Investors Destined to Fail?

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Right now, it looks like "sell in May" was pretty sound advice. But in fact, stock markets experienced an even sharper, faster, deeper dive in early April than they did in early May. The difference was that in April, prices rebounded by month's end, and then fell off the cliff a second time in May. But really, 99% of the market's gains were already "in the bank" by mid-March. There was nothing black-magical about May at all.

The so-called "Superbowl" theory is a popular one in amateur stock picking. According to stock market lore, a year in which a team from the old National Football Conference beats a team from the American Football Conference will be a good year for the stock market. This should have been good news for 2012's stock market, since the NFC Giants beat the AFC Pats. Obviously, the jury's still out on this one, but so far, the market hasn't given investors a touchdown yet.

Sports fans of a different stripe may prefer to peruse the SI theory. When an American graces the cover of SI's most popular issue, it supposedly means good news for the S&P. This year, Kate Upton was the chosen beauty, and she's sure enough American (born in Michigan). But let's not count on her to charm markets upward just yet.

Not all investors waited for the January results to come in, the whistle to blow on the Giants' victory, or the May score on the Dow, before deciding that 2012 was going to be a great year. This is "the year of the dragon" in China, and according to The Economist, "dragon" years have historically been the second-best performers of the 12 Chinese zodiac signs, producing about 11% nominal returns. So far, though, we had little to show for it -- at least until the big rally over the past couple of days.

Speaking of rash decisions, we alluded to this indicator in a story on the startling rise in cases of diaper rash spreading across the country in 2011, alongside increased sales of Desitin and dropping sales of disposable diapers. In theory, such signs of consumer belt-tightening should portend a stinky performance by the stock market. So far, this is looking like a pretty good guideline.

Now we come to what has actually turned out to be perhaps the best oddball indicator of all. Nearly a century ago, economist George Taylor touted the his theory connecting the length of women's skirt styles to America's economic fortunes. (The higher the hemline, the higher the stock market.)

Believe it or not, in February, Business Insider conducted an exhaustive report on the status of New York hemlines -- no, seriously! -- concluding that "overall, average hemlines in 2012 registered a 44.38 on the index, up from 35.04 for the Fall/Winter 2011 collections."

One week later, USA TODAY argued the opposite -- that hemlines at the New York Fashion Week were really down -- concluding we were in for "a mild slowdown." And just to make things interesting, self-proclaimed "trend forecast analyst" Harilein Sabarwal argued in April that what's really in fashion this year are asymmetrical hemlines that start higher, and slant downward.

Hey -- maybe this is the most accurate indicator of all!

This is probably a good place to acknowledge that Vanguard has some skin in this game: It offers 49 ETFs, and presumably isn't inclined to discourage folks from buying them. And, as Vanguard concedes, there is probably an element of self-selection at work, in that the sort of people attracted to Vanguard-practically a synonym for "buy-and-hold"-could be less prone to active trading than the overall investor population.

Vanguard notes, however, that a fund family which attracts more-active investors to its ETFs will likely attract them to its mutual funds, too. The whole point of the Vanguard study, says co-author Joel Dickson, is to document "relative trading activity"-namely ETF activity relative to mutual-fund activity-and to suggest that "the investment vehicle is not the source of that churn difference. Just because it's an ETF doesn't mean an investor's DNA automatically changes."

Dalbar's Harvey agrees. "In contrast with the premise that ETFs encourage stable investors to trade, I interpret the results as ETFs attracting investors who are intent on trading," he says. "The ETF temptation effect is an attractant, not a behavior changer."

In short, ETFs don't kill returns; investors do.

Vanguard, of course, is only one corner of the funds universe, as are ETFs. Since 2006, data provider Morningstar has tracked "investor returns," which are not to be confused with fund returns. If a fund returns 10 percent for some time period, its average investor almost invariably earns less than 10 percent, because he or she tends to get in and out of the fund at the wrong times.

In the five years through May 31, Morningstar's Terry Tian recently wrote, the gap between investor returns and total returns was 1.27 percent for the large-cap blend category, and 1.26 percent in short-term bond category. Over 10 years, the numbers fall to 0.39 percent and 1.02 percent, respectively, Tian wrote. It's worse with alternative funds-essentially those outside the stock-and-bond world. There, investor returns over the five-year period lagged total returns by an annualized 2.25 percent: the funds produced 0.21 percent, while the investor lost 2.04 percent.

And, just in case you're not thoroughly demoralized, let's not forget Dalbar's latest QAIB, which reads like a Harper's Index of investor haplessness. Among its more memorable items:
  • The average equity investor underperformed the S&P 500 by an annualized 4.32 percent over the past 20 years.
  • In 2011, the average equity-fund investor lost 5.73 percent, compared with the 2.12 percent simply holding the S&P 500 would have generated.
  • The average fixed-income investor underperformed the Barclay's Aggregate Bond Index by an annualized 5.56 percent over past 20 years.
  • Both equity and fixed-income mutual-fund investors have underperformed the market on a one-, three-, five-, 10- and 20-year annualized basis.
  • The average investor in asset-allocation mutual funds (balanced funds, target-date funds and the like) outperformed the average equity investor last year for only the sixth time in the past 20 years.
  • The average fixed-income mutual-fund investor has not kept up with inflation on a one-, five-, 10- or 20-year annualized basis.
At the root of all this pain are a handful of behavioral biases that this column will explore in greater detail down the road. For now, let's be thankful there is a hint of pleasant news from the good folks at Dalbar: The gap in the long-term annualized return of the average mutual-fund equity investor and the S&P 500 narrowed in 2011 (that 4.32 percent cited above), as it has more or less consistently since 2000, when it was 10.97 percent.

The reason, thinks Dalbar, is that investors who entered the markets in the 1990s "have now experienced multiple market declines and recoveries and have learned from those experiences. They found that remaining invested has, over the long term, produced positive results."

Who knew.

More from U.S. News Money:

How Not to Pick a Mutual Fund
Target-Date Funds Now Look Like Other Mutuals
Are Leveraged ETFs Just Double-or-Nothing Bets?
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