Are small investors really that bad?

October 4, 2012

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

(Reuters) – It has always been a tenet of faith in markets that individual investors are the financial equivalent of shark chum, forever bamboozled by news flow and buying high and selling low.

A close reading of the data reveals that things might not actually be all that bad.

If so, we might just have to revise our views, not just of individual investors but also of the role and contribution of financial advisers.

The classic view is that small investors are far too prone to being overwhelmed by news flow, selling out after plunges and buying after stocks or markets surge. This is known as the “behavior gap,” that margin between a market-neutral outcome and what we actually achieve in our fumbling.

Much of the intellectual underpinning for this view comes from the annual Quantitative Analysis of Investor Behavior report by analysis firm DALBAR, which attempts to measure the effects of investor decisions to buy, sell or hold mutual funds. here

A dollar cost-averaging investor, for example someone saving for retirement through regular systematic investment, would see huge differences in their returns depending on when in their savings the market had good or bad years.

If someone saves $1,000 a year and the market doubles in the first year but remains flat over the next nine, their dollar-weighted return would be 1.7 pct annually, against a market rate of 7.2 percent. Conversely, if the market is flat for nine years and then doubles in the tenth, they will handily beat the market, with a dollar-weighted return of 12.3 percent vs the same 7.2 percent for the market.

Interestingly, the average equity fund investor, for all her supposed foibles, actually managed to outperform systematic investors over the past 20 years, according to the study.

WHAT’S AN ADVISER FOR?

Given that we are at the end of a decade of lousy returns which was preceded by a decade of good returns, it is no wonder then that individual investors look to have lagged the markets, but this may have little to do with stupid behavior and everything to do with issues outside their control.

This is all a bit of a head-slapper for me. I’ve always believed that individuals make lemming-like decisions which open up opportunity for professionals.

If this is less true than we’ve assumed, then we need to have a look at where advisers actually create value for their clients. Believe me, I take as jaundiced a view of the average person’s ability to manage their own investment affairs as anyone, and yet one plank of that argument seems to be crumbling beneath my feet.

I haven’t got a lot of faith in the average investment adviser’s ability to pick stocks or even to allocate among asset classes – I simply don’t subscribe, for the majority of people, to the belief that trying to beat the market is fruitful.

Instead, I think advisers can really add value by changing behaviors among their clients, by educating them, frankly, to the risks and rewards so that their clients make better provision for the future.

It may be that hosing down investors when they are hell-bent on buying or selling isn’t really that much of a value generator. That doesn’t, however, mean that there aren’t client patterns of behavior which could profitably be changed.

Undersaving, based on an overly optimistic view of either future earnings or future investment returns, is one area, but advisers who are brutally honest about this have always risked losing their clients to other firms selling pipe dreams.

One other possibility worth considering is that the aggregate numbers on market timing are not that bad but that they contain huge numbers of people who are taking on far too much risk by moving in and out in size too often. Clearly those people would benefit from a nice, calm adviser.

In the end, though, we may just have to give the average market plunger a bit more respect than they’ve been getting – they may be as bad as we thought, but we can’t quite prove it.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by Walden Siew)

One comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

Info Corp.Is the reason he sends the most important fees the actual national football league, Spending typically $725 million a year for your legal protection under the law to the nation’s hockey management meeting. That get to typically $1.1 thousand single season using the new package. Sibel will pay you distinct because the nation’s nfl achieving is complete with alot of competitors in good trading sells making use of rhode island, Philadelphia, Chi town as well california..