Are We Still the Enemy? (Redux)


By David Sung, CFP, CLU, RHU

IN THIS ISSUE: How does the average investor miss out on 8.9% in returns each year? Simply by succumbing to their emotions — the ups and downs of the marketplace are not for the faint of heart or the itchy of trigger finger. When trying to protect our investments, we tend to make irrational decisions based on fear and reaction, “pogo-ing” from one investment to another. In this issue of Tactics, David Sung revisits the topic of investor behaviour and delves into the advisor’s role as a counselor and guide.

In August 2003, I wrote a newsletter entitled “Are We the Enemy?” Since then, many things have changed, but have our investment habits? Given the ups and downs of the investment markets as of late, I think it is worth revisiting almost exactly what was written before. This “redux”, or reflection on an old newsletter, has been re-written to address both clients and financial advisors alike.

To help set the stage, let’s say you and your financial advisor have just completed a detailed financial plan and part of this plan includes a thorough analysis of various funds and stocks. You’ve finally settled the new or rebalanced portfolio and now you are waiting patiently for the money to roll in. Over the course of a few months, however, you begin to see a decline in the value of your portfolio. You’re starting to think, “Something has gone horribly wrong and it’s time to take action. It’s time to sell. Sell gross and sell fast!” Sound familiar?

Many years ago, Walt Kelly’s most famous character, Pogo, declared: “We have seen the enemy and he is us.” For the past 13 years, Dalbar, a Boston-based financial services market research firm, has released its annual Quantitative Analysis of Investor Behavior (QAIB) report. Consistent with previous reports, Dalbar’s 2006 QAIB report concluded that the average investor may have underperformed equity markets by as much as 8.9% annually, suggesting Pogo was right. Are we, as investors, the problem? Are we the enemy?

This is where your financial advisor earns their keep. From an advisor’s point of view, educating investors and managing emotions suddenly becomes more important than all the work that was done structuring the portfolio. It is imperative to reach beyond the obvious investment and market due diligence that is required, and stand between investors and their emotions, safeguarding them from the potentially devastating effects of fear-based trading. I would argue that no other skill set has a greater impact on long-term returns.

An advisor’s role is to guide clients by helping them quell their fears, resist the urge to be a ‘pogo investor’, and prevent them from being their own worst enemy.

Aristotle once wrote that all human actions have one or more of these seven causes:

  • Passion
  • Nature
  • Reason
  • Compulsion
  • Habit
  • Chance
  • Desire

Judging by the 2006 Dalbar QAIB report, it seems that many human investment actions are influenced by all of the above causes – except reason.

Although most of us would like to believe that we make rational choices when it comes to our investments, the evidence suggests that many investors do not. In 1970 when Walt Kelly used the phrase “we have met the enemy and he is us,” he was using it to describe how humans often need to rationalize poor outcomes. In many cases, our own actions, not outside forces, create poor outcomes. In other words: “the enemy is us”. Never has this been truer than with investing.

Dalbar’s annual QAIB report is a study on investor behavior between certain time periods. The 2006 report covers the 20-year period of 1985 to 2005 and it comes to the same conclusions as past reports: despite major market indices posting impressive returns, the average investor earned only a fraction of these returns.

During the study’s 20-year period, the S&P 500 returned 11.9% annually; however, the average US equity fund investor earned a paltry 3% annually. Over this same period, the average annual inflation rate was 3.9%, thus the average investor clearly suffered dramatic financial losses despite the fact that the market experienced tremendous growth.

Lest you think it was simply the abysmal performance of those overpaid mutual fund managers, over this same time period the average U.S. equity manager had a respectable 11% average rate of return annually after fees. So investors were still 8% per year below what a monkey could accomplish throwing a dart at a list of mutual funds. How is it that the average investor managed to miss out on 8.9% per year?

The annual QAIB report provides strong evidence that investment return is far more dependent on investment behaviour than on fund performance, as the average investor was unable to hold on to their mutual fund investments through periods of volatility. Reacting quickly to market changes, they bought funds when they were expensive and sold them when they went down in value.

Commenting on a past Dalbar study, Heather Hopkins, director of marketing for Dalbar, said that “mutual fund investors who simply remained invested earned higher real investor returns than those who attempted to time the market.”

Are we preaching the “Buy, Hold and Prosper” mantra? Absolutely not. We’re simply highlighting that indices, or even funds, have tended to outperform the average investor not because they are better investments than what the average investor might have chosen, but because reactive emotional decisions tend to overrule the detached analytical synthesis of information that would allow us to make rational investment decisions. As James O’Shaughnessy wrote in his national bestseller, What Works on Wall Street:

“Markets often outperform the average investor, because they are always consistent and never vary. They are never moody, never fight with their spouse, are never hung over from a night on the town and never get bored. They don’t favour vivid, interesting stories over reams of statistical data. They never take anything personally. They don’t have egos. They’re not out to prove anything. If they were people, they’d be the death of any party.”

No recent period of time reveals this dilemma more clearly than the three-year period from January, 2000 to December, 2002. During this time, market volatility had many investors moving out of their funds and into cash at, possibly, the bottom of the market. Understandably, few things are more terrifying than extrapolating a 10% quarterly loss out over 10 years.

During periods when markets are volatile it is important that our client portfolios have what some managers affectionately refer to as a “thumb sucking component,” a consistent cash flow that gives investors a sense of security. Perhaps the element of cash flow income is what has always made a real estate investor a less fickle, more assured and, ultimately, more successful investor than most equity fund investors.

Of course, it’s not that real estate is a better asset, but the value is perceived to be greater due to the income generation of the property and not necessarily the market value. In many cultures wealth is not measured so much by net worth, but by income. In fact, this makes sense since our lifestyle and standard of living is a function of our income (or cash flow).

Unlike the stock market or mutual fund investor, owners of real estate do not receive a statement on a monthly or quarterly basis reflecting the value of their property. They have an idea of the market value, but what they really know is the income: the cash that flows into their bank account on a monthly basis. Stock market investors often have no idea what the income generation of their portfolio is; therefore, they perceive the value of their investments to be exactly what is reflected on the bottom line of their quarterly statement.

Take, for example, a $500,000 portfolio in October of 1996 invested equally into mortgages (with an assumed 11% return), high yield bonds (Trimark Advantage), income trusts (Guardian Monthly High Income), and dividend funds (RBC Dividend) – all incomegenerating assets. Using Globe HySales to crunch our numbers, by the end of 2002, this portfolio would have been worth $861,000.

Like a real estate asset, this portfolio had an average income of $46,013 per year. It is the income generation that offered the “thumb sucking component,” particularly when this portfolio’s market value would have taken a sizeable 12% drop in the fourmonth period preceding August 1998.

Common human nature would have many investors extrapolating that 12% out over the next few years and concluding that all their money would soon disappear. Faced with a sudden $73,000 loss, how does an investor behave rationally?

It is by virtue of the cash flow (the $46,013 in annual income) that an investor’s nature becomes somewhat pacified and they develop the ability to hold on to their investment. Holding on would have seen this same investment more than recoup its losses, all the while paying out $46,013 per year and generating a nice, tidy 9.2% average annual rate of return for the six-plus-year period.

Had an equity investor experienced a 12% loss without receiving cash flow, the discipline to hold on to the portfolio would have been far more challenging. Of course, this is where we see many investors realizing their losses and underperformance in both funds and markets.

Cash flow generates two main benefits: 1) it reminds us that we are continually earning money and inhibits us from making rash selling decisions, and 2) it allows us to reallocate cash to other investments at opportunities when values may be lower. We are forced to attend to asset allocation, not simply by buying and selling what is already owned, but by using the new cash flow to add to the portfolio.

Understanding that most of our investor decisions are probably driven by emotion, chance, nature, compulsions, habit, passion and desire – and not reason – it follows that investors should willingly seek guidance in these matters. An objective, reasonable and analytical third party (your advisor) could likely have helped the average Dalbar study investor bridge the gap between their dismal 3% annual return and the equity market’s 11.9% annual return.

It is here that an advisor provides true value. The media continues to write articles proclaiming that MERs (management fees) on mutual funds are expensive and erode investor returns. In many cases this is true, however, while fees and costs are an important factor in choosing an investment strategy, they pale in comparison to a disciplined, diversified, and value oriented approach that compels investors to see the advantage in picking unpopular assets when they least want to.

The Dalbar study is not just an analysis of investor behaviour, it is evidence of human nature. Investors get scared when they see nothing but losses with little to no gains – they panic. Nevertheless, there is a way to steady the ship; creating a portfolio that includes assets that provide cash flow can offer peace of mind.

Seeing a steady income in the face of losses is exactly the kind of pacifier “thumb sucking” investors need. It quells the panic and eases the fear. And any time we can eliminate those two problems, there’s a good chance we’ll be able to employ reason before an investment action, instead of looking for reasons for poor outcomes.

Clearly, the financial advisor’s role demands a broad-reaching skill set. They must possess not just an expert command of markets, global economic vagaries, and ever-changing financial planning matters, but must also have an aptitude for persuasion. They are constantly called to task as educators and counselors.

The ability to communicate with investors and resolve to make the right choices will ultimately define the long-term success of their portfolios. Beyond the obvious fiduciary responsibilities, advisors have a responsibility to protect their investors from themselves, from the emotions that might have them make detrimental, fear-based investment decisions.

As an advisor, it is never easy to tell a client that they are their own worst enemy, but the ability to do so may separate successful financial advisors from their less successful peers.

The Dalbar study shows that most investors, when left to their own devices, will significantly under-perform markets. Ironically, most investors (and the financial media) seem more concerned about fees than they are about sabotaging their own investment portfolios.

It is our job to show our clients that the nominal fees most professional money managers charge these days (1% or less), is money well spent, particularly when you consider the empirical data which suggests that without sound advice, investors may miss out on 8.9% per year.