As we emphasized in a December 2013 Mathematical Investor blog, individual investors are not very well equipped, and certainly not very effective, in managing their own investment portfolios.
This is unfortunate, because fewer workers than in the past, particularly in the U.S., are covered by a “defined-benefit” retirement system, namely a pension that guarantees a certain proportion of one’s income at retirement, based on the number of years in service, in perpetuity until one’s death. Instead, the majority of the growing army of American baby boomers (according to the Population Reference Bureau, 76.4 million Americans were born in the period 1946-1966) have to rely on 401K systems or the equivalent, where they must contribute (along with matching contributions, in many cases, by employers) to an investment fund that they have either partial or full discretion to manage. Indeed, more than any generation before, the present generation of workers will be personally responsible for their future financial well-being.
Other nations are facing similar challenges. In Canada, for instance, their version of “social security” provides only about half what it does in the U.S. In Australia, large employers such as universities typically place roughly 17% of a worker’s income into a “superannuation fund”. In New Zealand, this fraction is 7%. In Canada, pension savings are taxed as they are withdrawn, whereas in Australia superannuation funds are not taxed provided they are withdrawn as annuities. In continental Europe, mandatory retirement rules still exist, while in the English-speaking world, such rules, mercifully, are largely a thing of the past.
How well are today’s workers doing in saving for retirement? Sadly, more than half of today’s U.S. retirees will rely on Social Security for more than 50% of their total income, leaving them with the painful choice of either a rather severe drop in living standards, or else risking prematurely exhausting savings and being at the mercy of children or relatives. Many should at least lower their expectations for life after retirement, but there is little evidence that most workers nearing retirement are facing this unpleasant reality.
Of even greater concern is the level of skill with which most individual investors manage their nest eggs. We mentioned in our earlier Mathematical Investor blog a report known as the Quantitative Analysis of Investor Behavior, produced by the DALBAR organization, which attempts to measure short- and long-term success by individual investors. In that blog, we cited results from the 2012 report.
Now the latest (2014) edition of this report is available. So how well are today’s investors doing? The results are even more discouraging than in previous reports. The report notes that:
- Over the past 20 years, “equity fund” investors achieved an average 5.02% annualized return, which is 4.2% less than the 9.22% that he/she could have achieved by simply investing funds in an S&P500 index-tracking fund. This gap expanded in 2013, for only the third time in ten years.
- Over the bull market of the past three years, “equity fund” investors achieved only an average 10.87% annual return, lagging the average annual S&P500 return (16.18%) by 5.31%.
- Investors in “asset allocation funds” did even more poorly. Their 20-year average annual return was only 2.53%, lagging the S&P500 index (9.22% per annum) by 6.69% per annum.
- Investors in “fixed income funds” did more poorly still. Their 20-year average annual return was an abysmal 0.71%, fully 8.51% less than the S&P500 index, and 5.03% per annum less than the Barclay’s Aggregate Bond Index (5.74% per annum) over this time.
- Not surprisingly, investors show little evidence of skill in “market timing.” The DALBAR report notes that in the six best months of 2013, when the market was up sharply, there was no evidence that individual investors moved more than average amounts into equity funds.
As MarketWatch commentator Paul Merriman observes, the typical investor’s emotion-based trading in and out of securities based on fear and knee-jerk reaction to crises is counter-productive to long-term success:
Every year the conclusion [of the DALBAR report] is the same: On average, investors earn less than mutual fund performance figures imply. Sometimes they earn much less. … One conclusion: No matter whether the market is booming or busting, “Investor results are more dependent on investor behavior than on fund performance.” Investors who buy and hang on are consistently more successful than those who move in and out of the markets.
In our previous Mathematical Investor blog, we emphasized how the typical individual investor is relatively poorly educated and informed about making personal financial decisions. As the U.S. Securities and Exchange Commission noted in a 2012 report, “investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.”
These experiences are exacerbated by the larger plague of disappointing performance in mathematics and science education. This was underscored today with the release of the latest results for U.S. 12th graders on the National Assessment of Educational Progress (NAEP) test. The overall score of 153 in mathematics is identical to that from 2009, and is only slightly higher than the 150 score in 2005, in spite of years of effort and billions of dollars spent to improve K-12 education.
The DALBAR report concludes
Attempts to correct irrational investor behavior through education have proved to be futile. The belief that investors will make prudent decisions after education and disclosure has been totally discredited. Instead of teaching, financial professionals should look to implement practices that influence the investor’s focus and expectations in ways that lead to more prudent investment decisions.
Similarly, Louis S. Harvey, President of DALBAR, argues that
It is now past the time for the investment community and its regulators to understand that the principle of educating uninterested investors about the complexities of investing is unproductive. … We need a fundamental change that transforms investment thinking into meaningful decisions and choices for retail investors.
[Added 12 May 2014: A column by Chuck Jaffe summarizes a study by Natixis Global Asset Management on why investors often make poor financial decisions.]