When accounting for inflation, investors have significantly hampered their long-term real results, especially in fixed income, where the benchmark has produced a positive long-term inflation-adjusted return but the average investor has not!
To put the DALBAR results into perspective, a $5 million account would have grown to $8.9 million for the average equity investor earning a 2.9% real return over 20 years, but would have grown to $21.5 million if that investor would have simply bought and held similar equities over the same period. A fixed income investor would have actually lost purchasing power on an inflation-adjusted basis over 20 years and the same $5 million account would have declined to $3.7 million since the real return generated was negative at -1.5%. In contract, the Barclays Aggregate would have generated a gain of $5.8 million or a total account value of $10.8 million at the end of 20 years.
The DALBAR study estimates that psychological factors influencing investors’ decisions account for approximately half of the shortfall of returns. While many academics are quick to point out how active management trails passive management in a variety of studies, the aforementioned irrational trading behavior may partly explain this gap because portfolio managers of active funds have to respond to fund flows by either selling stocks at potentially the wrong time to fund redemptions or deploying new inflows in lesser conviction ideas. Either scenario can structurally hinder performance when compared to the scenario of the portfolio manager implementing their investment strategy without these complexities.
Since all the previous cases are hypothetical and subject to various other constraints that aren’t explored here, these examples come with the caveat that they are for illustrative purposes only. Additionally, the DALBAR study is only one study on the subject and there is no consensus on its methodology. However, the conclusion is relatively straightforward: the potential magnitude of this behavior can be quite large and significantly affect your long-term financial goals if your trading behavior mimics that of the “average investor.”
Our firm’s findings in our active vs. passive white paper³ remain the best way to succeed in resisting this wealth-destroying behavior. The tendency to want to fire an underperforming manager solely on performance and replace that manager with a manager who has recently done well is often counterproductive and is consistent with the wealth-destroying behavior measured in the “Dumb Money” paper. Our research group views active management as value-added over long-term periods if the investor is willing and able to remain patient and stick with the thesis for hiring the manager in the first place. That said, when changes occur to the organization, key decision makers leave the firm or changes are made to the philosophy and/or process, we will not hesitate to recommend a manager termination once the original long-term thesis has been altered.
For more information on our manager selection process, please contact any of the consultants at DiMeo Schneider & Associates, L.L.C.
