Peeking At Cards

Closing the Behavior Gap

Peeking At Cards
"Timing market entries and exits is a fool's errand." -- John C. Bogle, Founder, Vanguard Group

Market timing is and has been one of the most destructive investment ideas. Many studies have described, quantitatively, the returns of investors who engage in market timing versus those who don’t. We at Index Fund Advisors have also published our own research based on our clients' market timing behaviors. In virtually all studies, market timing has led to inferior investment performance.

In the mutual fund space, inferior returns associated with market timing are referred to as the “behavior gap.” The behavior gap is quantified by comparing dollar-weighted returns (what the investor actually got) to time-weighted returns (what the fund returned). A recent study conducted by Morningstar concluded that “the average annualized investor-returns gap for the 10-year periods ended 2012 through 2015 was -1.13%.”

Now some may think that 1% a year is a negligible amount, but, over time, the power of compounding returns can turn what starts out as seemingly a relatively unnoticeable pest into a very big parasite having feasted for years at your wealth accumulation. Consider this: the difference between the growth of $100,000 earning 5% per year and 4% per year for 10 years is $14,865 and a whopping difference of $46,217 over 20 years. 

The impact of the behavior gap has been the subject of much research, including ongoing studies from both Morningstar and DALBAR. According to DALBAR’s 2016 Quantitative Analysis of Investor Behavior (QAIB), mutual fund equity investors, on average, earned annual returns of 3.66% in the 30-year period ending December 31, 2015. The S&P 500, on the other hand, earned 10.35% per year over the same time period. Add global diversification with a tilt towards small-cap and value stocks with robust profitability, like IFA Index Portfolio 100, you would have earned 11.00% per year over the same time period. The chart below shows the annualized performance as well as the growth of $100,000 for the average equity investor, the Bank of America Merrill Lynch 1-Year US Treasury Index, the S&P 500 Index, and IFA Index Portfolio 100 for the 30-year period ending 12/31/2015.

As you can see, the growth of $100,000 for the average equity investor over the last 30 years was $293,992. Compare that to $357,705 by just sitting in 1-Year US Treasuries or even $1,919,420 in the S&P 500 or $2,289,230 in IFA Index Portfolio 100. Those numbers reflect the impact of the behavior gap. 

There are two important takeaways here. First, investors substantially hinder their expected returns by engaging in market timing, so much so that they would have been better off by simply buying and holding 1-Year US Treasury Notes--and avoided all of the stress associated with timing the markets. Second, over time the effect of compounding can turn a seemingly negligible returns gap into a much larger differential in ending wealth. 

The urge to time the markets is a very difficult instinct to fight. After all, who wants to sit tight through all of the ups--and especially the downs-- that come with an investment in the global equity markets? No one. But reams of research show that those who respond to an emotional imperative to forecast or to cut the short-term angst in down markets only damage their ability to earn the returns the market provides to long-term investors.

So how can we close the behavior gap? It all starts with education--and from the right teachers. It's important to know that CNBC, Money Magazine, Forbes, and the like have clients who are brokerage firms and active fund managers. The subject matter propogated by such media groups is not designed to make you a better investor, but to get you to trade. The behavior gap is what pays their salaries. You can rest assured the information they provide is not only useless, but potentially deterimental to your long-term wealth accumulation. 

At IFA, we take investor education seriously. To that point, please take some time to watch our newly released documentary film Index Funds: The 12-Step Recovery Program for Active Investors. The film was 2 years in the making, and we encourage you to watch it carefully. By learning more, you will increase your capacity to earn more--and you will be able to close the behavior gap for good--and for the better.