A clock stands in front of the offices of JPMorgan Chase & Co. in the business and financial district of Canary Wharf in London, U.K., on Tuesday, April 10, 2012. Bruno Iksil, a London-based trader in JPMorgan Chase & Co.'s chief investment office, has built derivatives positions linked to corporate credit that are so big he's moved markets, according to hedge fund managers and dealers. Photographer: Simon Dawson/Bloomberg
© Bloomberg

Timing the market is difficult. Our emotions make it even harder to get right. As a result, most of us — particularly retail investors — badly mistime the market, and so most investors in mutual funds do not realise anything like as good a return over the years as the published performance figures suggest we should.

All these things are well known. But the scale of the numbers involved still takes the breath away. This week saw the 21st edition of the Quantitative Analysis of Investor Behavior published by the US market research group Dalbar. Unfortunately still limited to the US, the report measures the returns actually made by investors in funds. If they sell their fund before the top, this will be reflected in lower returns than the fund makes.

Last year, the S&P 500 rose 13.69 per cent, and the average investor in equity mutual funds made 5.5 per cent. It was also a good year for bonds, with the Barclays Aggregate rising 5.97 per cent — but the average investor in fixed income funds gained 1.16 per cent. As for investors in asset allocation funds, for which it is maddeningly difficult to provide a benchmark, they made 2.24 per cent.

This is not a freak result. Over the past 30 years, the S&P has managed an annualised return of 11.6 per cent, far outstripping inflation, which has averaged 2.7 per cent. That should have provided a fine engine for Americans to turn their savings into a good pension. But over the same period, the average investor has managed a return of 3.79 per cent. Fixed-income fund investors gained 0.72 per cent per year. Investors in asset allocation funds, presumably a decent proxy for money actually invested for pensions, gained 1.76 per cent per year. That was less than inflation.

Underperformance by active managers, much covered in this column of late, has little to do with this. Lou Harvey, who produced the research for Dalbar, estimates that it accounts for about 0.3 percentage points of the shortfall. Fees also matter, as do “involuntary” sales, for non-negotiable lifetime events.

But the overwhelming driver is bad timing by investors. This is worst during extreme events. The months with the worst underperformance over the past three decades are headed by October 2008, when the S&P dropped 16.8 per cent in the wake of Lehman, but many investors bailed out before a rally at the end of the month, crystallising an average loss of 24.2 per cent.

There were also huge underperformances surrounding the Black Monday crash of October 1987, the Asia crisis of November 1997 and the Russian crisis of August 1998. But there was also a bad underperformance in March 2000, when the market did well. The S&P had already peaked, but it did not fall in a straight line.

It is no surprise that investors are most likely to panic at big market turning points. But they also underperformed last year, when with only one significant interruption the market slowly climbed higher. Many investors gave up on the rally early, and many also poured money in at the end of 2013, ready for the bad start to 2014, and then gave up.

There is some good news. Despite two epic sell-offs in 15 years, the gap between returns for the average investor and the index has narrowed over time. From 1998 to 2001, investors lagged behind the index by more than 10 percentage points each year. Last year was the fourth in a row when the gap was less than 5 percentage points.

Also, retention rates of funds are improving a little. Last year, the average period spent in an equity fund before selling ticked up slightly to just over four years. Over the past two decades, the average has been 3.4 years (while the average for fixed income funds has been even lower, at 3.08 years).

Such short holding periods are still not long enough to be sure of benefiting from equities’ long-term tendency to rise, or even to defray the costs of high front-end sales loads, which are still often charged.

Such numbers demonstrate why rigid quantitative strategies tend to work over time. Mass poor decision-making virtually guarantees there will always be someone on the other side of the trade when a fund tries to buy when others are fearful and sell when they are greedy.

But they also demonstrate that the way in which investment products are sold remains deeply flawed, even after decades of attempts at investor education.

What are the solutions? Mr Harvey suggests investment groups need a better grasp of marketing. The proportion of investors that keenly wants to beat the market is small — maybe 15 per cent of the total. More than double this number show extreme loss aversion, and the products such people need will be very different.

It would also help to design products that give an incentive not to bail out at the wrong moment.

Finally, the investment industry needs to acknowledge that it has made investment unduly complicated, largely in an attempt to justify the existence of advisers. Dazzling clients with a choice between a profusion of different funds seems good at first, but in practice it is disastrous — it merely exacerbates our strong human tendency to make emotional mistakes when investing. Less choice and more direction would help investors gain a greater return.


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