Saturday, August 01, 2015

Insanity Rules

Albert Einstein is legendary for his incredible contributions to mankind’s knowledge of the universe. Unfortunately, because of the enormous complexity of Einstein’s theories, the average human rarely has the intellectual capacity to understand their substance. However, there is one quote from this genius that should be easily understood. He famously provided the definition of Insanity as, “doing the same thing over and over again and expecting different results.”

You don’t have to be a quantum physicist to grasp that concept. Yet it has been proven that over time the average investor has failed to rely on this sage precept. But before we examine that as a manifestation of insanity, there is another aphorism also in play. It states, “It’s Not What You Know, It’s Who You Know.” The origin of that phrase goes back exactly 100 years, and I used it as a headline in Viewpointe over 13 years ago. Here is how that article opened (slightly updated):

The Bubba Syndrome

“We all recognize the important truths related to the above headline. Having personal contacts with individuals in important positions can sometime provide greater benefits than pure knowledge. An example is a well-known executive with the unlikely nickname of Bubba who was being interviewed in New York City by an executive headhunter as a potential CEO for a multi-national company. Bubba bragged about the influence he could exert through his personal relationships with important people throughout the world.

Bubba claimed he could arrange a meeting with any individual the headhunter named. In order to test him, the headhunter said to Bubba, “You know, because of all the corporate scandals taking place, as a potential CEO, it would be desirable to determine your relationship with the head of the SEC. In addition, since the company does a significant amount of business with the federal government, President Obama would be a good ally.

Bubba makes a few phone calls, and that very day, a lunch is arranged with Mary Jo White, chairperson of the SEC. Immediately after lunch, Bubba and the headhunter are whisked to Washington on Air Force One for a meeting with the president.

At that point, the headhunter, shaken but still somewhat skeptical tells Bubba, “You’ve about convinced me about your business contacts, but I have a personal request. As a devout Catholic, I’ve always yearned for a private, one on one meeting with the Pope, especially this new one.” Bubba says, “No problem.”

The next day, they fly to Rome, however, when they approach Vatican Square, a huge throng, awaiting the Pope’s appearance on his balcony, blocks the way. Bubba says, “Wait for me right here. Since I know the guards, I’ll get to the Pope and wave to you from the balcony as a signal that the interview is arranged, and then I’ll come back to get you.”

Sure enough, a few minutes later, Bubba steps out on the balcony with the Pope and waves. However, by the time he returns to get the headhunter, Bubba finds him surrounded by paramedics. He rushes over and asks him what happened. The headhunter, obviously in distress, replies, “They tell me I had a heart attack, and it’s all your fault. I was doing fine until you waved to me from the balcony, and the guy next to me says, “Who’s that guy with the funny hat on the balcony standing next to Bubba?”

Unfortunately, the average investor is not in a position to employ the type of personal relationships that Bubba seemed to enjoy. However, there are times that the above headline can be modified to read, “It’s Not Who You Know, It’s Who You Know About.” It is not necessary to actually know someone personally to benefit from that individual’s advice, experience, and influence (Warren Buffett for example). But you first have to know about the person, or in the case of this article, about an organization named Dalbar Inc. that recently gained news coverage in the Wall Street Journal, Forbes magazine, The New York Times and others.

The QAIB Impact

Dalbar, Inc. is a highly respected financial services market research firm. It was a pioneer in the development of the then new discipline of Behavioral Finance. Twenty-one years ago, in 1994 Lou Harvey, the creator of Dalbar came up with the idea to examine the behaviors of investors that influence the investment returns that they actually realize.

He initiated a study evaluating the behavior and the resulting long-term performance of mutual fund investors, and has provided an annual update each year since the report’s inception, titling it the Qualitative Analysis of Investing Behavior or QAIB.

Happy Anniversary

Ironically, this month is the 12th anniversary of an article that appeared in this column in Viewpointe, about that exact same organization, and not too surprisingly, about the very same subject being covered now in this article. And as you will learn, therein lies the relationship to the introduction of Albert Einstein’s definition of insanity. Apparently, according to the information that Dalbar reveals, investors have some sort of mysterious affiliation with that very malady. The August 2003 Viewpointe article referred to above, reported the following data based on Dalbar research at that time, and is quoted here:

“Imagine you invested $10,000 in the low cost Vanguard S&P 500 Index Fund in 1984 and allowed that amount to compound (in a tax deferred account) earning the benchmark rate of 12.2%. You might be surprised to learn that at the end of 2002, just 20 years later, your original investment would have multiplied almost ten-fold to $99,967. Would you have been satisfied with this performance that just equaled, but did not beat the benchmark? Most investors world not be contented. As a result, you might think that at best you were merely an average investor. Not so, as you will soon learn. Now we are going to assume you are a typical fund investor, so let’s try to determine if you rate as a below average, average or above average investor.

On The Other Hand

Instead of the above scenario, let’s assume that at the beginning of 1984 you believed you had the knowledge and skills to not only pick the best mutual funds (perhaps based on unique manager recent performance), but also that you possessed the ability to time the purchase and sale of the various funds in your portfolio. As a result, unlike the first scenario where you essentially followed the advice of Warren Buffett, and bought and held a security forever, you instead held a fund on average for only 30 months, chasing performance by switching into better performing funds or market sectors. You believed this strategy would allow you to ‘beat the market’ allowing you to become an above average investor. What would the actual results have been?

Dalbar determined that the above was the actual strategy implemented by the typical mutual fund investor. So, what happened to your $10,000 under those circumstances? That original investment grew to—would you like to take a guess here? — A mere $16,285, (just 16% of the amount earned by the above index investor) an increase of only 2.62% annually. No, there is no zero missing, that is the number that Dalbar reported, along with the comment that “[active mutual fund] shareholders followed a ‘buy high, sell low’ investment strategy. In essence, this type of investor turned out to be far below average, whereas the passive index investor who “merely” did as well as the S&P 500 Index deserves an above average rating.”

Despite the fact that the 2003 Viewpointe article cited a ten times out-performance by the S&P 500 Index over a twenty year period, the most recent numbers have declined sharply to “only” slightly less than two and a half times the most recent 20-year period. In retrospect, he former was apparently an anomaly (See below).

Is 30 Years Long Enough?

Dalbar now has 30 years of annual records that continue to show, although investor performance (and apparently investor behavior) seems to have improved, a performance gap still prevails. Over the 20-year period ending in 2014, Dalbart determined that a $10,000 investment in the S&P 500 Index grew to $65,464, compared to only $27,510 over the same period for the return of the average mutual fund investor. Think of it this way: If your beginning portfolio was worth $100,000 instead of just $10,000, had you invested in the passive S&P 500 Index Fund, at the end of 20 years you would have been worth $380,000 more than your fellow average mutual fund investor. Now you’re talking big money.

Based on Dalbar reports, if you average out actual investor returns compared to the S&P 500 performances over 30 year, 20 year, 10 year, 5 year, 3 year, and one-year periods, the index investor would have doubled the average investor performance.

Here is just one of the many conclusions reached by the Dalbar group: “After decades of analyzing investor behavior in good times and in bad times, and after enormous efforts by thousands of industry exerts to educate millions of investors, imprudent action continues to be widespread. It has become clear that improvement through investor education have produced only marginal benefits.”

Here Comes Albert

In essence, over a 30-year span mutual fund investors have been doing the same (wrong) thing over and over again, expecting different results.” I would hope that during the 12-year time frame since the 2003 Viewpointe article appeared herein, that some readers might have benefited by changing to an index format, thus avoiding the insanity epithet. If not Albert Einstein reigns.


Dalbar was a pioneer in the development of the then new discipline of Behavioral Finance. Twenty one years ago, when Lou Harvey, the creator of Dalbar came up with the idea to examine the behavior of investors that influence the investment returns that they actually realize, he determined that psychological factors account for 45% to 55% of the chronic investment return shortfall for both equity and fixed income investors.

For example, mutual fund retention rates suggest that the average investor has not remained invested for long enough periods to derive the potential benefits of the investment markets. Next month’s article will examine the behavior issues that deter investors from achieving parity with the benchmark index.


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