Nine Factors Behind Low Investment Returns

Bad behavior doesn't just cause high profile power brokers to get arrested and indigent borrowers to be granted mortgage loans they can't afford. It may be the root of something especially important to individual investors: low returns.

Mutual fund investors have earned unimpressive average annual rates of return over the past 20 years as they struggle -- sometimes unsuccessfully -- to keep pace with inflation. But don't fault the funds. Blame the investors.

Dalbar Inc., a fund research firm, says investment results are more dependent on investor behavior than fund performance -- and warns "destructive investor behavior" erodes the potential for better returns. Average investors chase performance, buying when markets are high and selling when prices are low, often in response to bad news.

Trading the news is a loser's game because it prevents investors from reaping the benefits of a long-term investment strategy. Mutual fund investors who hold on to their investments are more successful than those who time the market. But "recommendations by many mutual fund companies to remain invested have had little effect on what investors actually do. The result is that the alpha created by portfolio management is lost to the average investor," the Dalbar report notes.

Dalbar's 2011 Quantitative Analysis of Investor Behavior (QAIB) is the 17th annual edition of a report that examines the returns that investors realize and the behaviors that produce those returns. It measures the effects of decisions to buy, sell, and switch into and out of mutual funds.

The results consistently show that average investor earns less than mutual fund performance reports suggest, largely because of the impulsive or emotionally driven choices they make. For the 20 years ending December 2010, equity investors earned 3.83% and asset allocation fund investors earned 2.56%, compared to the S&P 500 return of 9.14%. For the same period, fixed income investors earned 1.01% compared to the Barclays Aggregate Bond Index return of 6.89%.

"Investors diligently seek investments that they hope will produce the best returns but lose much of that benefit when they yield to psychological factors," says Dalbar President Louis S. Harvey. What's behind the bad behavior?

Quite simply, human unpredictability. Standard finance models assume investors act with extreme rationality. But most don't. In fact, a number of recent studies confirm investment behavior often departs from what rational theory predicts. Individual portfolios are often under-diversified. Investors are overconfident. And buyers tend to favor attention-grabbing stocks.

Dalbar researchers suggest investors are driven to do the wrong thing by "psychological factors that overtake rational decision making," including:

• Loss aversion: Expecting high returns with low risk
• Narrow framing: Making decisions without considering all implications
• Anchoring: Relating to familiar experiences, even when inappropriate
• Mental accounting: Taking undue risk in one area and avoiding rational risk in others
• Diversification: Seeking to reduce risk by simply using different sources, giving no thought to how such sources interact
• Herding: Copying the behavior of others, even in the face of unfavorable outcomes
• Regret: Treating errors of commission more seriously than errors of omission
• Media response: Reacting to news without reasonable examination
• Optimism: Believing that good things happen to "me" and bad things happen to "others."

So what's the solution? Dalbar suggests investors will get better returns simply by pausing before reacting. The key is to "introduce a pause in the flow to assess the facts," the report explains.

Stop. Think. Then act. Sounds easy... on paper. It's harder to remain rational in real life. But there are key questions to keep you on track, Dalbar notes. We'll look at them in an upcoming post.