Investor Behavior Hurts Investment Returns

The biggest risk mutual fund investors face in earning a decent return may be their own behavior. A recent study by Dalbar, a financial industry research group, examined real investor returns over a nineteen-year period. It concluded that, �Investment return is far more dependent on investor behavior than fund performance.� Comparative returns show that the results of this �behavior� are truly threatening to the average investor�s portfolio.

Average Annual Return for period
January, 1984 to December, 2002

  • S&P500 Index �������� 12.2%
  • Average equity fund investor… 2.6%
  • Long-term corporate bond index � 11.3%
  • Average bond investor �����. 4.2%
  • Inflation ����� 3.1%

You would think that investment returns below the inflation rate would be as bad as it could get, but the real results are probably worse. This study did not even consider the high commission costs caused by rapid buying and selling of mutual funds, nor did it consider the tax impact of selling funds held for short periods of time.

And many investors did trade mutual funds rapidly. The average holding period for a stock fund was only 29.5 months, while the average holding period for fixed income funds was only slightly longer, 34.3 months. This is despite all of the attempts by the mutual fund companies, and the financial profession as a whole, to encourage investors to hold funds for the long haul.

The discrepancy in returns between the average investor and the indexes is easy to explain. The study found that investors continuously make the mistake of trying to �time the market� by buying funds when their performance is hot, then selling these funds when their performance inevitably turns down. The result is that investors do exactly the wrong thing, buying high and selling low.

A secondary cause for this underperformance of the average investor compared to the indexes is certainly the high cost of mutual funds (which is why we recommend that our larger clients use individual securities). But if we assume mutual funds cost an average of 2% per year, then mutual fund expenses still would only account for a small part of the discrepancy.

Given these dismal numbers, what should the average investor do? The study offered one approach. It noted that mutual fund investors who bought and held their funds did the best. Therefore, the results of this study suggest that, if you want to invest in mutual funds, you have to be able to resist the urge to meddle. Otherwise, turn over the reigns of your portfolio to a professional investment advisor. The larger your investments, the more important it is to use a professional.