Outperform 99% of Your Neighbors

Over 10 years ago, I was working diligently doing job my job as an investment advisor or financial planner (I was never sure what to call myself back then). As far as I understood it, my job was to search for investments that would generate above average returns for my clients. That’s what the entire industry was built on and really, that’s what clients thought they hired me to do.

Above average returns is called “alpha”, and finding even a little of it was worth any trouble. The search for alpha was why investment firms hired the bright people and gave them bigger computers than the “other guys.” As I was searching for a little alpha anywhere I could find it, I ran across a little annual study done by Dalbar. This study attempts to find out how investors did compared to the average investment. You see, investment returns are not the same as investor returns.

Investment returns that you see in the paper or in marketing material are based on the assumption that you invest a lump sum at the beginning of the period and then you leave it alone. You do not buy or sell. You do not change your mind and trade to another fund. You just buy once and hold.

Investor returns measure your real life return. The return you earned as you buy and sell your investments, or switch from one investment to another in your search for the next hot thing (remember our search for alpha?).

Well, for as long as Dalbar has been doing their study, the result has been shocking! The lastest update is not much different from the one I read over ten years ago. The study uses the S&P 500 as a proxy for the “average investment.” For the 20-year period ending 2007, the average investment return was 11.81%. The average investor return was 4.48%

Now think about this for a moment…the entire industry is based on the idea that their job is to find the best investments, and in the process, they are killing the patient. The well-intentioned search for alpha is resulting in the average real-life person under-performing the S&P 500 by over 7%. That is crazy stuff.

When I realized the implications, my entire job changed. I realized that investment success is not about skill—it is about behavior. I could not figure out why this story was not being told anywhere. I even remember reading an issue of Consumer Reports that went into great detail about how to save a percent on fees by buying no load mutual funds. Then, buried in the article was one sentence that mentioned the Dalbar study and warned people about this 7% problem.

Three pages devoted to saving a percent, one sentence that mentioned a massive problem but offered no ideas for solving it! I started telling the story everywhere I could. I drew this sketch on the whiteboard in every client meeting and at every public speaking engagement.

behaviorgap_600

It turns out my job was not to find great investments, but to help create great investors. If all you had to do was buy good (versus great) investments and then behave correctly that changes everything. I decided that the search for alpha didn’t matter (turns out it’s a fool’s errand anyway, but I didn’t know that at the time) if you lost 7% in the process just because of bad behavior. I decided to leave the complex task of finding the best investment to smart guys with the big computers; I was going to focus on the simple problem of helping people behave correctly.

It turns out that outperforming your neighbor is not about finding better investments, it is about behaving better.

outperform_600

Wow, if this is true, think of what it does to your life. No more Jim Cramer, no more late nights after work trying to find the next Microsoft.

If this is true (year after year, studies tell the same story) then the focus is really on the few things that you control.

If this is true, your relationship with a financial planner should be based on trust.

If this is true we can focus on the simple, but not easy, task of becoming a better investor.

I’m very exciting to see that other people are talking about these issues, too, including:

I was also asked by J.D. at GetRichSlowly.org and Ramit at IWillTeachYoutoBeRich.com to provide a guest post. If you get a chance, I encourage you to check them out.

By Carl on 02.11.09 > Link

Tagged as: Behavior Gap, Dalbar

  • this is a great article. thank you for sharing your strategy with us.
  • he returns by funds and investment newsletters are always presented as compound returns if you invested a lump sum at the start and stayed fully invested. By that method, you'd be indifferent between returns that increase in a straight line, or returns that go skywards at the beginning and take a nosedive at the end -- it's all the same as long as they both go from A to B. Pity the guy who dollar-cost averaged into the second scenario though.
  • this blog is great. the content is crisp and very interesting :) thank you so much and keep up the good work
  • vijay19121984
    Investment behavior is the only sure-fire way to make money. No matter what the economy does, peoples actions are predictable.search engine optimization
  • hmmm, in reading the report, I am becoming very skeptical.

    How can the "Guess Right Ratio" ever be anything except 50%. For each person that 'guessed wrong' there has to be someone who 'guessed right'. It the nature of any market.

    There is some oddity in their methods that they aren't making clear. Don't make their findings invalid, but makes me skeptical
  • Since the professional money so dwarfs the non-pro money, there is almost no opportunity for alpha. Since every move a pro makes is offset by another pro (every buy by a manager is a sell by another), it is impossible to funds to beat the averages. In other words, they are the averages.
  • grahamhmichaels
    Over 10 years ago, I was working diligently doing job my job as an investment advisor or financial planner (I was never sure what to call myself back then). As far as I understood it, my job was to search for investments that would generate above average returns for my clients. That’s what the entire industry was built on and really, that’s what clients thought they hired me to do.Above average fidelity 401k returns is called “alpha”, and finding even a little of it was worth any trouble. The search for alpha was why investment firms hired the bright people and gave them bigger computers than the “other guys.” As I was searching for a little alpha anywhere I could find it, I ran across a little annual study done by Dalbar. This study attempts to find out how investors did compared to the average investment. You see, investment returns are not the same as investor returns.
  • @Murray:

    Wow, thanks for thoughtful comment. I hope as we continue this discussion that all your questions will be addressed (maybe not answered to your satisfaction, but at least addressed). I will be writing more about the cause of the behaviorgap in future posts, but for now let me just make a few final points:

    1- I am not so concerned about whether the behaviorgap is 2% or 8%. I just know that it is there.

    2- I am talking about the difference between the average fund and the average fund investor. While the gap between the average fund and the index is very important (mainly due to costs as you pointed out) that is a debate I will leave for people much smarter than I.

    3- From everything I can find, the major cause of the behaviorgap (at least on a functional level) is chasing hot performing mutual funds.

    4- While I understand your point that if the behaviorgap exists there must be a way to take advantage of it, I am not interested in taking advantage of it. I am interested in helping people make sure it doesn't happen to them. If you look at one example, the Janus Enterprise Fund. According to Morningstar over the last 10 years the fund returned -1.72 but the average investor in the fund earned -12.97. This is dramatic example, but my focus is on making sure that doesn't happen to people. I am not concerned about (and really not smart enough) to worry about how to benefit from that huge gap, I am just focused on closing it.

    Hope that helps you understand where I am coming from.
  • Adam
    Hi Carl,

    I found your blog via lifehacker. I'm excited to see someone finally summarizing all the statistical fallacies associated with "finding alpha" in such a succinct and pithy manner!

    In one of the white papers in your "Lab" you discuss the importance of investing like an adult with the specific example of a globally diversified portfolio, with an asset mix of 60% US stocks.

    I am curious what you think of simply putting that 60% directly into a low cost ETF such as SPY to track the performance of US stocks exactly (more specifically, it's the S&P 500 in this case.) You could alternatively split this between different ETFs such as the IWB or the Nasdaq QQQQ.

    The most important feature of such a move is the ability to "fix it and forget it" -- namely, little rebalancing if any is required, avoiding the all-too-human desire to pull out when times are bad or switch to something hot when times are good. For example, if your long-term goals are 20-40 years down the line, why not just put your stocks allocation into ETF index funds now and continue to add to those funds in the future? This way you are literally tracking the investment, and not becoming the investor exhibiting 'the behavior gap' that gives this blog its name.

    (I'm not the first person to come up with this idea. For example, it's been discussed here: http://www.fool.com/investing/mutual-funds/2006... but note that this author makes precisely the same mistake discussed on this blog -- namely, assuming that one COULD have picked the BEST actively managed funds. Hindsight's always 20/20, and the average investOR would not have done that, right Carl?)
  • @Adam: a few more thought:
    1- Thanks for the kind words about the site. Glad to have a few life hacker
    readings here.
    2- The key to avoiding these mistakes is putting things in place to prevent
    yourself from making the classic ones. In these case it is true that "we
    have seen the enemy and it is us".
  • @Adam: I think that would be a great approach. As John Bogle says, there
    might be a few ways to improve on that strategy, but the number of ways to
    do worse or infinite!
  • Murray
    Thanks for the reply Carl. Now that I know that you recommend a passive investment approach I can agree that those following your advice have a good chance to “outperform 99% of their neighbors”. I assume you agree with Bogle that the gap identified by the Dalbar study is not entirely due to behavior, but a large chunk is due to the costs of active management.

    I don’t quite understand your reasoning in point 3 and 4. The papers I cited do not study stock picking or investments. They used a methodology very similar to the Dalbar study to determine how the average invested $ fared compared to a buy-and-hold $. So they are trying to determine if the average investor’s market timing strategies are successful. I urge you to read these papers if you haven’t done so, because they are very relevant to the issues you raise in you blog. I realize that you and Dalbar refer to Mutual fund investors which will yield different results to these papers, but I think there is an overlap.

    On your point 6, I would like to offer an example: Let’s assume a grossly simplified stock market with a market cap of $100. There are only 2 investors. Mutual fund (MF) owns $50 and Warren Buffet (WB) the other $50. A big bear comes along in year 1 wiping out 50% of its value. So both MF and WB now have $25 invested. MF runs scared and sells out, the only buyer is WB. So at the start of Y2 MF owns $0 stock and WB owns $50. Year 2 sees 100% market gains. Lets assume that cash earns nothing. At the end of Y2 MF has $25 so he lost $25 over the 2 years. WB has $100 after investing $75 over the 2 years, giving a gain of $25. The market as a whole started with a cap of $100 and ended up with a cap of $100, thus gaining $0. I don’t understand why this argument does not apply.
  • Carl, you're no longer 'our' little secret! :)

    Tell me, how did your clients respond post your revelation? Presumably part of the reason investment advisors act like they do is because clients demand they chase performance?

    I imagine for some alpha type personalities, being told to put money in an ETF would be a cue to find a new adviser.

    Keep up the great work!
  • @Peter: Thanks for the kind words.
    1-I am not a big fan of target date funds (I will talk about that more).
    2- Look for passive investments that are low costs (eft, vaguard index fund, Dimensional Fund Advisors)
    3- The forum run by the bogleheads is a good place to get started: http://www.bogleheads.org
    4- Find a great advisor that will help

    Hope that helps. I would be happy to address it most specifically via email as well.
  • @Murray-

    1-I am a huge fan of Bogle's.
    2- Most really good advisor's I know DO assist their clients in taking a passive approach to investing
    3- Picking individual stocks is a fools game. It does not work. The two papers you cited are just two more in a huge body of academic work that proves that point.
    4- That is still missing that point. Those are investments. I am talking about investors. When you look at the average REAL person out there that invests in mutual funds they have been less than satisfied with their results. Whether that gap is 2, 4, or 7 percent misses the point.
    5- Rather than running around looking for a better way to pick investments I am focused on helping people (using low cost passive solutions) behave better to close the gap that we all know exists.
    6- The arguement about taking the other side of the trade simply does not apply when you are talking about chasing the latest hot performing mutual fund.

    Hope this helps, thanks for the very insightful comment
  • Murray
    Your analysis fails to mention an important part of the puzzle. In ‘The battle for the soul of capitalism’ John Bogle presents this analysis:

    US equity funds 20 years 85-04

    Total stock market 13.20%
    Average fund 10.40%
    Difference 2.80%
    Average investor 7.10%
    Difference 3.30%

    He ascribes the shortfall of 2.8% between the TSM index and the average fund to costs as follows:

    Expense ratio 1.20%
    Portfolio transaction costs 0.70%
    Survivorship bias 0.50%
    Sales charges + other 0.40%
    Total 2.80%

    So the gap between the index and the average investor is 6.1% of which 2.8% comprises costs. Your behavior gap is actually only 3.3%. In my view your 1st priority as an advisor should be to give your clients the benefit of the low hanging fruit – cost savings. You should advise them to invest in low cost index funds. The Vanguard total stock market fund has an expense ratio of .19%, transaction costs are .04% and there is no survivorship bias problem. I guess a good advisor can justify .5% for his fees. This means that at least 2% of the gap can be closed by cutting costs. If you only concentrate on behavior your clients will miss out on this 2% saving.

    As for the 3.3% behavior gap – closing it is no sure thing.
    1st The very existence of this gap is still in dispute. Here are links to 2 peer reviewed academic papers on this subject. http://papers.ssrn.com/sol3/papers.cfm?abstract...
    http://papers.ssrn.com/sol3/papers.cfm?abstract...
    The 1st paper finds that buy-and-hold returns exceed dollar-weighted returns by approximately 1.5%. This research reviews the total stock market, not just mutual funds per the Dalbar study. The 2nd paper debunks the 1st and finds no evidence that this gap exists. The debate is still unresolved, I don’t think advisors can tell their clients that closing this gap is a sure thing if the academics are still debating its existence.
    2nd If there are indeed a group of investors who consistently underperform the market due to mis-timing, then it should be very easy to consistently outperform by simply taking the other side of their trades. Why should your clients be happy with market returns if it’s so easy to beat the market?
  • Peter
    Hi Carl, I came from J.D.'s and Ramit's blog, I really enjoy your clear and simple writing.

    I've read from several places that it doesn't make sense for a small investor worried only about his retirement to invest in a mutual fund but should go with a total market balanced portfolio like Vanguad's Retirement funds. I have a Vanguard 2045 account which invests 90/10 in stocks/bonds. I've also heard if you want to invest extra money and not do any of the homework then take a market ETF which has minimal fees. That way you can invest in the market average. What's your take on it?
  • Great article. Discipline when investing is something I know many investors overlook when they attempt to critically examine their returns and why their expectations haven't met their performance.

    Good blog!
  • Excellent article! It is so true!
  • Clifford
    Hi Carl, I came across a link to your blog on www.bogleheads.org. It just happens that I posted some information about what peter is talking about. If you invest monthly you should get less than half of the profits of the investor who invests his money all at once. Here is the link to my post.
    http://www.bogleheads.org/forum/viewtopic.php?p... .
    I came across a picture a few years ago on a day trading site that you should like, I have no idea who made it.
    http://img26.imageshack.us/img26/779/tradinglx3...
  • Ok, I'm hear and I'm listening.
  • james001
    It turns out that outperforming your neighbor is not about finding better investments, it is about behaving better.I have studied a article by Daniel Manson.what a great writer Daniel Manson is, about how many different things he writes about.
  • @Peter: On a macro level it really is as simple as looking a fund flows. Money routinely moves from mutual funds based on the recent past performance. If the past performance is good, people switch from "bad" funds into this "good" funds, just in time for the normal cycles to change. That results in a the average investor underperforming the average investment by some significant margin (whether it is 4 or 7 or 2 percent misses the point)

    On a individual fund level you can see it using Morningstars Investor Return data. Here are a few examples:

    These are all 10 year annualized returns for the last 10 years (ending 1.31.2009)

    -Janus Enterprise Fund: -1.72%. Average investor: -12.97%.
    -AIM Energy Fund: 16.00%. Average investor: 9.86%
    -Lord Abbett Small-Cap Value: 9.01%. Average Investor: 5.72%

    I know it is crazy, but it happens all the time.

    If you care to hear is how Morningstar calculates Investor Return
  • Peter
    So to expand on my point: I wonder if it's an issue of measurement / flawed methodology. I'm a business academic and have worked a lot with market research agencies -- a methodological flaw is far from unthinkable to me, I've seen worse than that from people who are supposed to be experts.

    Specifically, if for funds you're looking at annual compound return, and for individuals dollar-cost averaged return, you'd be comparing apples with oranges. I'm not saying that this IS the case, but it's something worth looking for in the original study.
  • Peter
    Interesting article. I'd read about this in a review of John Bogle's latest book "Enough".

    I wonder if this could have something to do with dollar-cost averageing in a market period with inverse U-shaped characteristics.

    The returns by funds and investment newsletters are always presented as compound returns if you invested a lump sum at the start and stayed fully invested. By that method, you'd be indifferent between returns that increase in a straight line, or returns that go skywards at the beginning and take a nosedive at the end -- it's all the same as long as they both go from A to B. Pity the guy who dollar-cost averaged into the second scenario though.

    Really, the returns we should all be looking at are those of someone dollar-cost-averaging into a fund.

    I wonder if that explains the big discrepancy, because as the other poster says, if some people get less than 50% there's got to be someone on the other side getting more than 50%. The institutional vs individual argument doesn't convince me. Isn't the point that most of these individuals invest via institutions anyway?
  • @Patrick: I am glad it started to make sense.

    You hit the nail on the head: disciplined rebalancing between asset classes would close the gap. The problem is that no one does it! Rebalancing requires you to buy low (relative to other asset classes) and sell high (relatively).

    SIMPLE, but not easy!
  • Patrick
    I read through the link and understand better. The 11.8% vs. 4.84% was just for equities. So, portfolio composition didn't matter. People actually did better with equities than with bonds and cash, which would seem hard. It seems the major mistake is not buying when the markets are bottoming. They suggest constant dollar cost averaging. However, I would also think disciplined rebalancing between asset classes would also help.
  • @Patrick-

    This is a wild concept to get your head around so your wise to want to see the data. The major study is done by Dalbar and a link to it can be found here in the comments. The only way to see their data is to pay for the study. The other thing you can do is look at the work that Morningstar is doing in this area. For each fund that has a certain length track record (I believe it is 5 years) the are now publishing what they call an "Investor Return". In almost every case it is lower then the funds return because it is human to want more of what is doing well (buy high) and get of what is doing poorly (sell low).

    I hope you understand that I am not so interested in exactly how large or small the behaviorgap is, or even in the raw data that it exists (even though I do study it). I am interested in help people understand that it exists. It doesn't take much to see that on average we buy high and sell low. That is proven out time and time again by money flow (see my other comment to Kevin).

    So hang in there and we will have more up soon. Hope that helps.
  • @Kevin: very good question. The gap is caused not by people exiting the market as a whole, but rather chasing the hot "area" or asset class within the market. I will talk more about it in future posts, but it is unbelievable how often there are huge inflows into asset classes right after they have been hot (and just before the get killed). The latest was energy. Back in the summer when oil was over 140 a barrel all you heard was how it was headed to 300. Guess where the majority of the money flows were, into energy related investments. Just in time for it to be cut in half.

    I wrote a little about this in "The BehaviorGap: A Snapshot which you can find in "the lab" but I will be addressing it in a more in depth post soon.

    It's really amazing how time after time huge amounts buy high and sell low. That is the major cause for the behavior gap.
  • Patrick
    How can the “Guess Right Ratio” ever be anything except 50%. For each person that ‘guessed wrong’ there has to be someone who ‘guessed right’. It the nature of any market.

    Depends on how you define "investor." If it is everyone in the market, then you are correct. If it excludes people managing other peoples money (i.e. only individual investors), then return does not have to equal the average.

    But you do hit on something that validates the whole idea. Since the professional money so dwarfs the non-pro money, there is almost no opportunity for alpha. Since every move a pro makes is offset by another pro (every buy by a manager is a sell by another), it is impossible to funds to beat the averages. In other words, they are the averages.

    Investor returns would be lower for paying fees, taxes, poor manager performance, poor diversification, and wrong asset allocation.
  • Patrick
    While I think your post and central concept are absolutely correct; I would be curious to see the raw data. For instance, if the S&P 500 returned 11% and bonds 6%, and the average investor was 50/50, then investor performance would be 8.5%. But they did not underperform by 2.5%, because they were expected to return 8.5%.

    Like I said, I don't know if that is factored in. I would suspect a better benchmark would be how the average portfolio is constructed. If the average is 60/35/5, then I would use a benchmark that had 60% of the S&P return, 35% of the bond return, and 5% of the cash return. Then see how the investor return compares. Since 90% of return is allocation and only 10% is other factors like timing, that would be more interesting.
  • Kevin H
    hmmm, in reading the report, I am becoming very skeptical.

    How can the "Guess Right Ratio" ever be anything except 50%. For each person that 'guessed wrong' there has to be someone who 'guessed right'. It the nature of any market.

    There is some oddity in their methods that they aren't making clear. Don't make their findings invalid, but makes me skeptical
  • Kevin H
    Where is that 7% going? Either you are talking about MEAN investment return and MEDIAN investor return, or people are paying on average 7% of their potential earnings in fees. Knowing which it is helps you define how to change behavior.
  • Carl, nice post. I'm gonna have to seriously think about studying investor behavior rather than investment behavior.

    -Nate
  • Investment behavior is the only sure-fire way to make money. No matter what the economy does, peoples actions are predictable.
  • @The Personal Finance Playbook

    Here's a link to the 2008 DALBAR study with data through year end 2007:

    http://www.thorntonwealth.com/storage/library/D...
  • Thanks.
  • That link is actually broken. They may have taken it down. I don't know. I searched their site for it and found commentary on it but not the actual study.
  • I really like your site, too. Could you link to the Dalbar study? Is it available online?
  • @Oblivious, Neal & Steven: thanks for the feedback. Please feel free to chime anytime you see something that needs correcting.

    @Oblivious: I really like the site. You are spot on. Very few people are talking about the idea that it is really about becoming a better investor by avoiding the big behavioral mistakes NOT hiring folks with bigger computers to continue the search for the better investment.
  • Steven
    Fascinating post. My subscription is in the mail.
  • Ditto. Great work. Super writing. Keep it up!!!!
  • xyz
    Wow, if this is true, think of what it does to your life. No more Jim Cramer, no more late nights after work trying to find the next Microsoft.
    If this is true (year after year, studies tell the same story) then the focus is really on the few things that you control. ductionar engleza
  • Hi Carl. I'm absolutely loving your blog so far. It's very cool to find somebody else who focuses on the same thing that I do--the idea that how you invest is at least as important as what you invest in.

    Keep spreading the word!
  • bonnie001
    This market is too hard for 99 percent of investors It turns out that outperforming your neighbor is not about finding better investments, it is about behaving betterBonnie
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