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Chart(s) of the Week – The Effect of Inherited Volatility

shareasimage inheriting volatilty

 

In yesterday’s quote of the week we looked at the findings of numerous studies focusing on the average investors’ underperformance to a stated fund’s annual returns. This underperformance stems from investors trying to time the stock market, attempting to buy and sell multiple times per year in attempt to outperform the general market and chasing returns by buying yesterdays “hot” funds hoping the returns continue. Mr. McNabb, Vanguard’s chairman and CEO, calls this behavior “inheriting volatility”. In this week’s Chart(s) of the Week we are looking at exactly how much investors are hurting themselves over the long run. 

 

Below we are looking at the results from 5 studies on the issue. In each chart below we assume the following:

  • $10,000 initial investment
  • $5,500 additional investment each year thereafter
  • 30 year investment horizon
  • “Fund Return” is the stated return of the funds in the study
  • “Investor Return” is the estimated actual return from the average investor. Also known as the “Dollar Weighted Return”. (See our post yesterday for more on this, how it is calculated, etc.)

 

With that in mind, let’s start at one of the most often cited studies. The “Dalbar” study, which got a lot of press for its findings – probably because they are so shocking. As a note, this study found the largest gap between investor return and reported fund return of any of the others studies we look into here.

 

Dalbar Study:

 

 

How do two investments compare over 30 years if one returns 11.11% annually and the other 3.69%? Take a look below:

 dalbar

 

A difference of $930,155 with our assumptions!

 

 

Next up is a study from Morningstar, here the study is looking at the results from ALL funds (not just equity or domestic equity like most of the studies featured here).

 

Morningstar’s study:

 

The long term difference between the fund return and dollar weighted investor return for this study:

 morningstar_study

 

For a difference of $216,288 over 30 years!

 

 

Next up, a study from researchassosicates.com:

 

 

The study also breaks down results for value oriented funds, growth oriented funds and both small and large cap funds. Results reported above includes all funds, but for those interested in the breakdown of other fund classes, check out the link above.

The long term difference between the fund return and dollar weighted investor return for this study:

 research_associates_study

 

For a difference of $242,727!

 

Next we look at a study from Harvard Business School focusing on Hedge Fund investors. Hedge fund investors are typically very wealthy, as hedge funds typically have high minimums. Do these “sophisticated” investors perform any better than the average joe with a Scottrade account?

 

  • Fund return: 13.80%
  • Investor / Dollar Weighted return: 6.10% (7.70% underperformance)
  • Study reviewed returns from 1980 – 2008
  • Numbers above are for the portion of the study focused on hedge fund investor returns.
  • Study can be found here: http://www.people.hbs.edu/gyu/HigherRiskLowerReturns.pdf

 

 

The long term difference between the fund return and dollar weighted investor return for this study:

hbr_study

For a whopping difference of $1,665,310!

 

 

And lastly we look at the “Maymin – Fisher study”

 

 

The study is a short read and attempts to look into the possible causes of the underperformance as well. Worth a read if you are interested.

The long term difference between the fund return and dollar weighted investor return for this study:

 

maymin_fisher_study

 

For a difference of $173,362!

 

 

Conclusion

 

Each of these studies have to make some assumptions in their calculations, but in the end they reach the same conclusion; Investors on average only hurt their returns by buying and selling around market moves.

Maymin and Fisher sum it up better than I could in the conclusion of their paper:

“Investors chase returns and by doing so harm themselves. They chase returns by allocating more to funds that perform well and by adjusting prices to reflect their mistaken beliefs that past performance will repeat. Simulation results using historical means and standard deviations predict that investors will allocate about 25% more to outperforming funds as would be expected solely from their performance, and this prediction is borne out by the data.”

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