THE average holding period for mutual funds, as measured by US-based research firm Dalbar, appears to have deteriorated - a trend that does not bode well for investor returns.
In its 2008 Quantitative Analysis of Investor Behaviour, Dalbar has found that almost invariably, the long-term returns reaped by individual investors are a far cry from those represented by indices or the marketing material of fund companies.
This is because of a tendency to try to time their investments and to hold for significantly shorter periods than those reflected by fund marketers.
One way to improve returns is through dollar-cost averaging, or 'systematic' investing. The benefit of dollar-cost averaging can be dramatically improved by increasing one's contributions over time.
- Dalbar's 2008 Quantitative Analysis of Investor Behaviour
Over shorter periods of one, three and five years, however, returns seemed to have improved somewhat, which Dalbar attributed to lengthening holding periods. Now, however, as the credit crisis and worries over a weak US economy cause volatility to rise, fear of loss may well undo the gains of the recent past.
First, the long-run returns. Using mutual fund sales and redemption data, Dalbar found that over the 20 years ended December 2007, the average equity fund investor would have earned just 4.48 per cent a year, compared with the S&P 500's annualised return of 11.8 per cent. This translates to an under-performance of more than 7 per cent a year.
Fixed-income investors fared worse. The average investor's annual return was just 1.55 per cent, compared with the Lehman Aggregate Index of 7.56 per cent and also losing out to inflation of 3.04 per cent.
The asset allocation (balanced fund) investor did better in terms of beating inflation, with a return of 3.45 per cent.
Over shorter periods, returns were actually respectable. The one-year return for the equity investor, for example, was 7.13 per cent, against the S&P 500's 5.5 per cent. And over five years, the investor earned 12.51 per cent, against S&P's 12.83 per cent.
Dalbar believes that this was due to a longer holding period of over four years, as measured between 2002 and 2006. But last year the holding period dropped to 3.89 years. The trend may have plateaued due to the credit crisis and economic downturn. Investors, Dalbar said, 'may not have the patience or emotional wherewithal to weather market dips'.
Holding periods for asset allocation funds were longer at 4.45 years, although this was down from 5.11 years in the previous study. Such funds, said Dalbar, have created a 'comfort zone' to help protect investors from their own errors. 'While traditional performance measures show that asset-allocation funds severely under-perform equities, they encourage smarter behaviour that may help avoid significant losses.'
Retention, or staying invested, is the key to success. Few investors manage to consistently avoid downturns. 'During the last 20 years, equity investors would have realised monthly gains 65 per cent of the time - in other words, their chances of making money would have been nearly seven in 10,' said Dalbar.
On market timing, Dalbar uses a 'guess right' ratio to measure individuals' success rate. The ratio measures how often the average equity investor 'guesses' the direction of the market, based on net mutual fund inflows and outflows. The investor guesses right when there is either a net inflow each month followed by a market rise, or a net outflow followed by a downturn.
Dalbar says that over a 20-year period, equity investors were more right than wrong. However, the periods of incorrect guessing had an impact on their portfolio. The guess right ratio was highest - 67 per cent or eight out of 12 months - during years when the market posted strong returns, and lowest during market declines. Overall, the guess right ratio for 20 years was 61 per cent.
During the period of 'irrational exuberance' in the late 1990s, the guess right ratio fell. 'Perhaps because mutual fund investors, overconfident in the rising tide of the tech sector, guessed wrong as they moved away from the protection of diversified mutual funds and into direct investments in dotcoms and telecoms,' said the study.
One way to improve returns is through dollar-cost averaging, or 'systematic' investing. A simulation by Dalbar based on an initial capital of US$10,000 found that the average equity investor who invested systematically would have reaped 50 per cent more returns at the end of 20 years. The fixed-income investor would have earned 196 per cent more in returns. And the asset allocation investor's additional gain would have been 116 per cent.
Moreover, the benefit of dollar-cost averaging can be dramatically improved by increasing one's contributions over time, said Dalbar.
The firm said that the study shows that returns increase when instinctual reactions are replaced by disciplined investor behaviour. Most people need a financial adviser to 'coach' the required discipline. 'The most important role of (an adviser) is to protect clients from themselves - to discourage behaviour that erodes their investments and savings,' it said. 'Financial advisers need to be part financial analyst, part emotional therapist, offering clients practical strategies to help them maintain their focus during times of crisis.'
This article was first published in The Business Times on May 7, 2008
