The Power Of Passive Investing

April 20, 2011

The most recent Dalbar study covering a 20-year period ending in 2009 found that equity mutual fund investors had average annual returns of only 3.2 percent while the S&P 500 averaged 8.2 percent, and ?xed-income fund investors had average annual returns of 1.0 percent, while the benchmark Barclays Capital Aggregate Bond Index averaged 7.0 percent.

Dalbar found a nearly 5 percentage point gap between equity funds and fund investors, and a 6 percentage point gap between bond funds and fund investors. These are extremely large shortfalls for investors. Are individual investors and advisors really that bad at timing the markets? The data compiled to date suggests they are.

Market Timing Gaps
A bear market in stocks tends to happen about every ?ve years and lasts about a year and a half. Studies on investor behavior show that people act very differently during down markets than they do in up markets. Basically, they’re scared in bear markets and brave during bull markets.

The Dalbar Guess Right Ratio measures how often and when the average investor makes smart decisions to get in or out of the stock market in general. This ratio also shows how often the average investor realizes a short-term gain by either buying or selling mutual funds before a market rises or falls. A reading above 50 percent is positive and a reading below 50 percent is negative. Figure 2 illustrates the Guess Right Ratio through 2009.12

Ironically, investors are right about the stock market’s direction in more years than they are wrong, as shown by the disproportionate number of years when the ratio was over 50 percent. However, when investors are pessimistic, they dump stocks. The wrong years tend to occur in the recovery after a bear market, and investors miss the rebound.

In a Gallup Poll of investors taken on March 4, 2009, just a few days before the market bottom, only 18 percent of investors believed the stock market would show a sustained recovery by year end; 27 percent thought it would take two years, 25 percent said three years; 19 percent said longer. About 2 percent said the stock market would never recover.

Only 18 percent of the investors surveyed in the Gallup Poll guessed right. The S&P 500 gained 67 percent from its intraday low on March 9 until year end.

Figure 2

Morningstar Studies
Morningstar weighed in with a comprehensive study on dollar-weighted versus time-weighted returns. They calculated the 1-, 3-, 5- and 10-year time-weighted returns and dollar-weighted returns through 2009 for open-end mutual funds based in the United States.

The Morningstar study found signi?cant de?ciencies in investor timing decisions. U.S. equity fund investors experienced a negative 1.4 percent gap in return over 10 years while bond fund investors experienced a negative 1.3 percent gap over the same period. In aggregate, the timing gap was negative 1.5 percent across all asset classes and sectors.13 Figure 3 illustrates the difference in major asset class returns for the period.

Figure 3

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