Overreaction leads to Underperformace

Have you ever heard of the Dalbar study? This company does an annual study that looks at the impact of investor behavior on returns. What they’ve found is that over time not only do mutual fund investors underperform the market, but they also underperform the underperforming mutual funds. Wow…that’s a lot of underperforming.

This underperformance is attributed to picking the wrong mutual funds and getting in and out of the market at the wrong times. Since it is impossible to time the market, I would argue that it is always the wrong time to be getting out of the market.

Here’s an example of a chart Vanguard put together using data from the Dalbar study:

source: Vanguard

What do YOU do when the market gets scary?

The answer to this question should be “nothing” or “buy more”. Sadly, research shows that many people do exactly the opposite. Selling everything when things are scary can feel good and provide a sense of safety in the short term. These same people will buy back in ‘when the coast is clear’, which typically means prices are much higher than when they sold in the first place.

For your long-term investment strategy, sitting out of the market is the one big mistake that you can’t afford to make. With craziness looming in North Korea and other parts of the world, it would be easy to self-justify getting out of the market right now. But when do you get back in?

Do you remember how Greece’s economy was going to destroy global markets? How about the fiscal cliff and government shutdown? Oh, and let’s not forget about the debt ceiling or the flash crash. For eight years the market has continued to rise, quickly recovering from any number of fear-inducing events. Over longer periods of time, short-term declines aren’t even noticeable.

It can best be summed up by a chart I have framed on my desk at work from Behavior Gap.

The Value of a Financial Advisor

I am a Do-It-Yourself investor. I think most anyone can successfully manage their investments without a financial advisor. Financial advisors will point to the chart above and argue that you need to have your accounts professionally managed to protect you from yourself. While there may be some truth to that, I think all you need is someone who can talk you off the ledge.

Even though I am a DIY investor, I have a financial advisor. He is someone I used to work with and trust his judgment and integrity. He doesn’t manage my accounts, but I get free dedicated access to him because of the size of my accounts. We talk a few times a year and he helps validate that I’m still on track to reach my goals.

If I ever were considering selling everything, he would (hopefully) be able to talk some sense into me and prevent me from making that huge mistake. The real value of a financial advisor is when they can remind you of your long-term goals in times of short-term uncertainty.

3 thoughts on “Overreaction leads to Underperformace”

  1. There have been questions about the accuracy of the DALBAR studies. I talk about it in this post: http://www.mindfullyinvesting.com/update-to-article-4-1-on-fear-and-greed-problems-with-the-dalbar-studies/

    I had to slightly revise one of my old articles as a result, but my conclusions were still the same and very similar to yours. That is, there is still a significant gap between individual investor performance and the performance of the funds themselves. It’s just that the gap is not as big as DALBAR seems to make it out to be. Nice article. Keep on blogging!

  2. You definitely want to be skeptical of a report that is funded by the very industry that profits from the findings. There are certainly people who need protection from themselves, but there’s no reason they couldn’t do so with an arrangement like mine. I have a fully self-directed account but have access to a free sounding board if I ever feel the need to use it.

  3. Love your quote: “Since it is impossible to time the market, I would argue that it is always the wrong time to be getting out of the market.” Very true…you need to be in it for the long haul if you want to see a true return on your investment.

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