19 August 2017

Why Most Investors Lag Behind the Market

#
Share This Story

The average stock investor’s earnings lag significantly behind the market as a whole. Precise estimates vary as to how much, but the main reasons for many individuals' under-performance are quite simple: chasing returns, and excessive fees.

‘Fear and Greed’: Lessons from Behavioral Finance Theory 

A recent study by the Boston-based financial-research firm Dalbar found that the average investor in all U.S. stock funds earned 3.7% annually over the past 30 years, while the S&P 500 stock index had an annual return of 11.1%. In other words, the market outperformed stock-fund investors by about 7.4% annually over three decades.

What accounts for this gap? For one, the return on funds – and market indices like the S&P 500 – are measured as if an investor put all of their money in at the beginning and then left it untouched for the entire period. But most investors will put money in and take money out along the way.

Also, most funds lag the S&P, probably accounting for about one percentage point of the gap in the Dalbar study. And, as will be seen below, fees and expenses account for at least one more percentage point in the aggregate figure. Then, further muddling the picture, many believe the Dalbar figure overstates the gap between investors and the market (more on that below as well.)

But to the extent that the average investor really does lag behind the market in investment performance, the biggest culprit is what behavioral finance theory refers to as chasing returns. Many investors jump into the market after a hot streak and then flee when it goes the other way, and because they buy high and sell low, oftentimes investors in the typical fund have a lower average return than the fund itself.

In measuring an investment’s returns over time, only those who held the investment for the entire time will match that performance. In actuality though, some will even do better if they manage to buy low and sell high, but most will do worse. For example, one study found that stock investors lagged behind the stock market itself by 1.3 percentage points between 1926 and 2002. Others have show that even pensions and other “sophisticated” or institutional investors earn about three percent less than the hedge funds they buy. Still others show that mutual funds tend to outperform their investors by between one and two percentage points annually.

That is because on the whole, when the market heats up, money flows in, and when it cools down, it exits. Critics of the Dalbar figure, which indeed appears to show a much larger gap than these others, believe that it exaggerates the truth because, rather than using a standard formula that adjusts the results based on when performance was earned and when money was introduced or withdrawn from the fund, its calculation takes returns over the full period and divides them by total assets at the end, including money that wasn’t there from the start.

But even if it is an exaggeration, it describes a real phenomenon. Money rushing in at the top of the market means a portfolio manager has no choice but to buy overpriced stocks, while, conversely, investors fleeing the market at the bottom means he has sell the stocks right when they become cheap. (Then to rub salt in the wound, after the manager sells stocks to cash out the investors who flee, any attendant capital-gains taxes will be shouldered solely by the investors who stay.)

So what can you do? For one, you can look at Morningstar.com, where the “performance” tab at each fund’s page enables you to compare fund returns against investor returns. Then if the gap between the two numbers is greater than one or two percentage points, you can look for another fund that is less welcoming of hot money.

And, perhaps, you can do better than your fund if you are disciplined about adding money when markets fall and then holding firm (or trimming a little) when markets are on the rise – or, in other words, buying when you feel like selling, and vice versa.

But if there is one other main lesson to take away from the Dalbar study, it may be this: part of the (much larger) gap that it shows between investors and the market likely stems from its method of comparing the returns of fund investors to an index over time, rather than to the funds themselves. While, from one perspective, that might mean that it overstates the impact of “chasing returns” on investor performance, from another it appears to provide a compelling argument for the average investor to simply buy index-tracking funds and then hold onto them to the extent that such is feasible.

That way, if they cannot beat the market (i.e. consistently, over time), at least they probably won’t do much worse. Unless, that is, they become a victim of excessive fees.

To Get the Most From Your Money, Keep an Eye on the Fees 

We’ve already seen how investor behavior can hurt performance, and that actively seeking to beat the market is, for the average investor, a quixotic pursuit almost certain to fail (especially over extended periods of time, as life’s needs and wants intrude on optimal investment strategy) – and that most investors will likely do much better by instead simply trying to track the market’s performance. But that is only one side of the coin for maximizing investments. The other is avoiding and reducing fees in any and every way possible, whether in hiring an investment adviser or putting money into mutual funds.

Most fees can be reduced, negotiated or eliminated by shopping around and haggling, and the payoff for such efforts can be substantial.

For example: An investor who had $200,000 in a mutual fund would pay $2,500 based on the average annual fee, while the same sum in a broad-stock-market index fund could cost as little as $80. Over 30 years, with fees and returns compounded annually, that gap alone would cost the higher-fee investor about $570,000, if both investments return 8% a year before fees.

Moreover, when interest rates are low, and many investments generate unexciting returns, the impact from lowering costs can be particularly notable.

Paying fewer fees means more money saved and more money working for you in your account. Fortunately, there are a number of ways for a cost-conscious investor to do so, both in seeking financial advice and making investments.

Financial Advice 

Advisers at large Wall Street banks typically charge investors around 1% of the value of assets under management per year, and they provide a variety of services, such as helping clients to plan for retirement, choose an appropriate balance of investments and pick individual stocks and funds.

Investors can cut that fee significantly if they can make do with less hand-holding.

Many independent financial advisers will prepare a bare-bones financial plan, including a household budget analysis, a projection of retirement needs and a model portfolio of stocks and bonds, for $500 to $1,500, according to  Eleanor Blayney, a consumer advocate for the Certified Financial Planner Board of Standards in Washington.

While those services probably wouldn’t include actually managing a client's money, for an investor with a portfolio of $200,000, that could mean saving $500 or more. (Moreover, many advisers at Wall Street firms will only work with clients who have $500,000 to $1 million or more to invest.)

Also, any investor who wants to hire an adviser should meet with at least three candidates, and should not hesitate to ask an adviser to lower fees if a competitor charges less for the same service.

Then there are other low-fee options, including a fee-only planner who charges by the hour or project, and who is often the least-expensive choice. Such arrangements can work well for an investor who only needs a quick consultation.

Another option: Go virtual.

Many new firms offer financial advice over the Internet, and while they might not capture the nuances that a traditional adviser would spot in a face-to-face meeting, they generally charge less.

In some instances, investors can get matched up with financial planners who may, for example, put together five-year plans for retirement preparation, debt management and savings. Then investors who want recommendations for how much of a portfolio to allocate to stocks or bonds can pay an additional fee, and then implement that strategy.

Other companies automate that process. Prospective clients answer short online surveys about savings goals and risk appetite, and the companies generate recommended portfolios of low-cost ETFs based on computer algorithms. If you like what you see, you can set up an account and they will make the investments.

Discount Brokerage 

Stock-trading fees have fallen sharply over the last few decades. In 1991, Charles Schwab charged $74 a trade, according to research by Aite Group, a Boston data firm.

Starting in 2010, the drop became more acute as discount brokerages tried to lure back investors who had cut down trading activity after getting burned by losses in the financial crisis.

Active investors can still benefit, as prices haven't bounced back up. Currently the average fee per trade is $8.82, according to San Francisco-based NerdWallet.com, which tracks financial firm fees.

Investors who trade infrequently, or who will do most of their trading right after they open an account, should check for promotions that might let them avoid fees altogether.

Mutual Funds and ETFs 

Mutual-fund fees have been coming down in recent years. But there is still a big difference between what a typical investor and a cost-conscious investor might pay.

Fees vary greatly based on a number of factors, including the fund company, the type of asset and the management style.

The average mutual fund had an expense ratio of 1.25% in 2013—or $125 annually per $10,000 invested—down from a peak of 1.47% in 2003, according to Chicago-based investment-researcher Morningstar. But for many types of funds, investors can do much better.

For example, consider the return on a $100,000 investment in the Vanguard 500 Index Fund, which is designed to track the S&P 500. It charges 0.05%. If the Vanguard fund has an average annual return of 8%, before fees and taxes, at the end of 30 years the investor would have more than $990,000, if fees and returns were compounded annually.

On the other hand, the investor in the average mutual fund would only have about $710,000, assuming the same pre-fee return.

For another example, one of the target-date retirement funds offered by Vanguard has an expense ratio of 0.18%, while other comparable options charge between 0.7% and 1.1% annually.

In general, index funds and ETFs tend to have the lowest fees, and when deciding between funds that track the same index, "virtually every time, you should go with the lower cost fund," says Russel Kinnel, who researches funds for Morningstar.

To cut expenses even more, investors might consider ETFs that track slightly obscure indexes that are similar to pricier peers.

For example, an investor might traditionally use an S&P 500 ETF to invest in large-company stocks. However, according to ETF.com, the cheapest large-cap stock ETF is Schwab U.S. Large-Cap, which has an expense ratio of 0.04% and tracks the Dow Jones U.S. Large-Cap Total Stock Market Index. (See the lowest-cost ETFs for various fund categories in the table on this page.)

For ETFs, investors also will want to make sure that the fund's "bid-ask spread" isn't more than three cents for a stock ETF and five cents for a bond ETF. The spread is the difference between the highest price that a buyer will pay and the lowest price at which a seller will sell, and a large spread can quickly offset the cost advantage of a low expense ratio.

Finally, while actively managed mutual funds tend to carry higher costs than index funds, investors in active funds should also make an effort to limit fees. Generally, investors shouldn't pay an annual fee of more than 1.25% for U.S. large-company stock funds, more than 1.75% for U.S. small-company stock funds or more than 1.5% for U.S. bond funds. To see a mutual fund's expense ratio and how it compares to the average, look up the fund at Morningstar.com and click on the "Expense" tab.

The higher the manager's fee, the harder it will be to beat an index fund, and, once again, most managers fail to do so consistently.

This article includes information drawn from research in the Wall Street Journal.

Join Our Online Community
Join the Better Way To Retire community and get access to applications, relevant research, groups and blogs. Let us help you Retire Better™
FamilyWealth Social News
Follow Us