The gap between fund performance and investor performance

One tool I have looked at a lot is Dalbar’s Quantitative Analysis of Investor Behavior, known by many as simply the Dalbar Report. It is a study that looks at the last 20 years of data. They have been doing this study for over 10 years. It a rolling study in that each year, they add the latest year and drop the oldest year. Then they look at how investors are doing that invest in mutual funds.

The results? Not good! At the end of 2010, the 20 year average of the S&P 500 was 9.14% while investors in mutual funds averaged 3.27%. Yikes! So does the report say WHY there is such a big gap between the index itself and investors? They claim it is investor behavior and basically their fault for only holding a given mutual fund for less than three years.

You see, Dalbar sells the report mainly to financial advisers telling them that not only must they help their clients pick good mutual funds, but they need to do a little bit of hand holding and have them stay the course when they pick a mutual fund.

I investigated criticisms of the Dalbar Report a bit, curious what members of the financial community thought of this. After all, how often have you heard these damning statistics against mutual funds? Did your HR department send this information out in an annual notice along with other news about 401K options? Didn’t think so.

It appears there is one big concern with Dalbar’s methodology. What I read was wordy, but could be summarized simply as, the first ten years were during the Great Bull Market, while the last ten years were during the Lost Decade. Strangely, this criticism seemed to attack the explanation of the gap, meaning it wasn’t 100% the investor’s fault, and that comparing these two figures was like comparing apples to oranges.

The Great Bull Market was a highly unusual time period. It stretched from 1980-2000. The equities markets grew strong during this whole period. If you had a lot of money in the markets at this point in time, you would have done well. But when 2000-2001 hit, we got a major market correction. What made things much worse, was that another correction hit in 2008. In my personal research of looking at S&P 500 data going back to the 1950s, it appears that we encounter a market correction about every 10 years, so missing one for 20 years almost demands this double correction.

But at the end of the day, what does it matter WHY there is such a gap. What is critical in putting together a wealth building plan is to look at investor performance and realize that mutual funds don’t work. This fact of there being ten good years followed by 10 flat years just proves the existence of sequence of return risk and how insidious it can be. To solve this problem, we don’t need to debate whether or not investors are to blame for their actions over the past 20 years. Instead, we need to build a plan that assumes this behavior will continue, as it has each year since Dalbar began their studies.

We need a combination of tools that will help us build wealth without causing us to panic during down years, like rent producing real estate. Buying a handful of stocks that not only have a solid history over decades, but also involve products we fully understand would also be helpful. Finally, putting a chunk of our accumulated wealth into a EIUL, a vehicle that was designed to avoid losses as well hedge against inflation and future taxes. All of these tactics, when used together can provide a much more effective approach to building wealth. No longer are we betting on the appreciation of mutual funds, but instead accumulating assets that will yield cash for us in retirement with protection from the tax man.

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