MORE disciplined behaviour among US investors has perked up returns accruing to individuals, a US study has found. But long term returns remain meagre when seen against a simple buy-and-hold strategy on the S&P 500 index. The annual study by US research company Dalbar, the 'Quantitative Analysis of Investor Behaviour' delves into mutual fund flows to produce a picture of investor behaviour. It covers 20 years of real investor returns for equity, fixed income and asset allocation funds between 1987 and 2007.

Dalbar sets out to make some points on investor behaviour that are worth taking to heart here in Singapore as well. Foremost is that timing the market does not work.

Over one year, the average equity fund investor enjoyed a return of 14.7 per cent compared to the S&P 500's 15.8 per cent, and beat inflation of 2 per cent by a wide margin. Over three and five-year periods, the average investor actually beat the S&P500. Dalbar attributes this relative success to longer retention or holding periods.

But over 20 years, the average individual return was only 4.3 per cent, against the 11.8 per cent return on the S&P using a buy-and-hold strategy. The long term inflation rate is 3 per cent.

Returns for investors in bonds and other fixed-income securities were worse. While the individual beat the long term government bond index over one year - 2 per cent against the index's 1.2 per cent - the 20-year return was dismal. The individual's return was only 1.7 per cent against the index's 8.6 per cent.

As for asset allocation or balanced funds, the individual's return paled against the equity-only S&P500. Dalbar, however, says such funds encourage longer holding periods which translates into 'investors making more money'.

Dalbar says: 'Whether the mutual fund industry is enjoying rapid expansion in times of economic boom, or is being battered by the bears, the key findings uncovered in (the) first study from 1994 remains true: Investor return is far more dependent on investor behaviour than fund performance. Mutual fund investors who hold their investments are more successful than those who time the market.'

In Singapore, fund flows are tracked by research company Lipper on a quarterly basis. CPF also gives a snapshot of investors' profits and losses on an aggregate basis. But it is difficult to glean individual holding periods from the data, and returns are typically reported on the basis that a fund is held for the relevant period.

Dalbar says: 'While mathematically useful, there are virtually no investors that exhibit this behaviour, making published returns applicable to no one ... Investors are motivated by greed and fear and not by sound investment practice.' Tracking the dollars going into and out of a given month, compared to market performance, proves the correlation, it says. As markets rise, cash flows swell. As markets fall, cash flows deflate.

The data posits two broad types of investors. One is the 'average' investor, which assumes that a $10,000 investment is made in a pattern similar to average investor behaviour. This is inferred from fund sales, redemptions and exchanges as provided by the US-based Investment Company Institute. There is also the 'systematic' investor where a $10,000 investment is evenly distributed across each month.

Of guesses and gains

The 'guess right' ratio reflects the frequency with which investors make a short term gain. A point is awarded for every month that an investor sees net inflows and the S&P 500 rises the following month. A point is also scored when there is a net outflow and the market declines the following month.

The 'guess right' ratio is strongest in rising markets (1992, 1995, 1996-97, 2003-2006). But the most mistakes are made during downturns. 'These mistakes occur because investors are driven by the fear that markets will not recover ... If you don't know when to get out, it is better to stay in,' it says. The overall 'guess right' ratio over 20 years is 61 per cent.

Comparing 'average' behaviour to systematic investing, Dalbar found that $10,000 invested systematically using dollar-cost averaging yielded 40 per cent greater returns. 'It is clear from this analysis that behaviour drives the returns that investors actually receive. Good investment behaviours compensate for major underperformance,' it says.

It tested this by comparing a systematic approach with just 75 per cent of S&P 500's return against the 'average' behaviour: the disciplined approach still outperformed.

Loss aversion - people's tendency to prefer avoiding loss than making a gain - is the greatest influence on behaviour, says Dalbar. This is the main cause of loss among mutual fund investors. 'The imprudent response to risk is very often based on the fear of catastrophic loss.'

Concern about risk is greatest in three instances - when an investment decision is required; after a loss and after news of a loss by others. These events present the best opportunities for risk education, says Dalbar. 'Risk education must first correct the fear of catastrophic loss by providing anchors to establish risk as being relative, and then include explanations of how risk is controlled ... The biggest risk is getting out before the upturn.'

The average holding period among equity investors is 4.3 years. This has been so from 2002 to 2006. Before that the holding period ranged from 1.7 years in the late 1980s to about three years between 1992 and 1996. Retention is critical, says Dalbar, as one cannot benefit if one is not in the market. 'While it is highly profitable to avoid market downturns, very few investors do so successfully ... After all, the market moved up 60 per cent of the time and down only 40 per cent for each month of the last 20 years.'

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