I was recently conducting a portfolio review with a newer client of mine when the subject of “activity” (or rather, “inactivity”) came up.  The question was, why was her portfolio being managed in such a seemingly passive way?  Shouldn’t we doing in more trading, buying and selling or exchanging of funds?  (My quick response was that as a matter of policy our firm takes the time to select mutual funds early in the planning process that are well matched to the client, and which properly diversify the portfolio from the beginning.  Then we leave it alone.  But it is an important question and one that I would like to elaborate on here.)

In the case of this particular client, we were looking at a portfolio that engages in significantly less risk than the market overall, and yet the year-to-date return of her portfolio was only nominally under-performing the S&P 500 index of stocks.  How could it be, she asked, that a portfolio consisting of only 55% stocks could essentially match the performance of the total stock market, during a period of time when the stock market had risen?

Let’s start with a distinction.  There are two kinds of behavior when it comes to investing:  investment behavior, and investor behavior.  (I suppose there is also advisor behavior, market behavior and economic behavior, but we’ll leave those for another time.)  Investment behavior refers to the performance of a particular stock, mutual fund or funds, or how a particular fund has done over a given time period.  By contrast, investor behavior relates to the performance of the person who invests in that fund or group of funds; in other words, to the performance of her portfolio over time as she buys and sells and exchanges from one fund to another.

Luckily, there is a quantifiable way to draw this distinction, one which contrasts the results of actively traded portfolios with more static, buy-and-hold type of portfolios.

Enter Dalbar, a leading edge investment research and communications firm which has been examining this distinction since 1994, measuring the effects of investor decisions to switch into and out of mutual funds over both short and long-term time frames.  The results consistently show that the average investor earns less – in many cases, much less – than the mutual fund performance of the funds they invest in.

Results of sixteen years of studies has yielded two assumptions:  1) investment results are more dependent on investor behavior than on fund performance, and 2) mutual fund investors that hold onto their funds are more successful than those who attempt to time the market, over each of the 20-year periods examined.

How much more successful?  For the period ending 12/31/2009, the S&P 500 returned 8.10% for the last 20 years (the 1990′s and 2000′s).  Over this same time period, the average equity investor just barely beat inflation (2.8%) with an annualized return of only 3.17%.  Thus, the premium on return for investors who simply chose a fund stayed with it (rather than buying and selling and chasing returns) was around 5%.  What does that mean?  Well, on a $100,000 investment, a portfolio earning 3.17% annualized over 20 years becomes $186,667, while the same amount earning 8.10% grows into $474,803.  That’s an extra $288,136 for buying a mutual fund and then looking out the window for the next 20 years.  And when you factor in that there are equity funds that periodically outperform the S&P 500, the results can be even more pronounced.

What drives investors toward inappropriate behavior?  What leads them to believe that they can out-smart and out-perform the market?

For many, investing is a hobby, and as such lends itself to over-activity for the sake of activity.  For others it may be more about self-deception; the belief that unlike most everyone else they can successfully exploit information and consistently beat the market, despite mountains of evidence to the contrary.  (The fact that they may be beating the market during smaller, random time periods may only succeed in building an unrealistic sense of accomplishment.)  For others still, it is perhaps the notion that to do well you should be doing something… shouldn’t you?

It is those using this last rationale that stand to benefit most from the Dalbar studies.  For these investors the results are more than instructive, for they reinforce behavior that has been shown again and again to lead to better investment results over time.

That certainly won’t be enough to sway every investor, but you can’t blame me for trying.

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