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Editor's note: Originally published on August 18, 2014

A company named Dalbar sells an annual study of investor behavior and relative investment returns to financial advisors. The chart below has been making the rounds. Advisors use it as a marketing tool to show potential clients just how poorly the average investor does versus aggregate market returns of various sectors and strategies. Unlike the other 20 year average returns shown on the chart, the “average investor” return reflects the impact of the amounts and timing of investment and disinvestment. In short, investors do poorly because they are poor at timing their allocation of funds within and between different asset classes. The other (market) average returns assume a constant level of investment.

I suspect that a large proportion of the assets of the “average investor” are either directed or heavily influenced by a financial advisor. Presumably, this analysis is used by advisors to encourage investors to invest what they can over time into whatever mutual fund the advisor thinks will do well going forward.

Two messages here:

  • There is a dramatic difference between apples and oranges; and

  • Unless you are better than "average" it is likely that you and your advisor have proven over time to have poor asset allocation and forecasting skills.

The most important factor in the dramatic difference is the sequence of returns and when the investor makes their investment. The Dalbar study points out that as poorly as the average investor does, they still do better than the systematic investor applying the dollar cost averaging approach, 33% better. Consider this simple example of the importance of the sequence of returns:

  • If a market doubled in the first year, then remained flat for 9 years, the 10 year average market return is 7.2%. If you invested $1,000 every year into this market, at the end of 10 years you would have $11,000 and have realized a 1.7% dollar-weighted average annual return.
  • Now suppose that this market stayed flat the first 9 years and doubled in the tenth year. The average market return is still 7.2%. You would have $20,000 at the end of ten years, or a dollar-weighted average return of 12.3%.

Even though there are long term bull and bear markets that can last 20-30 years, there are dramatic market downturns that occur about twice a decade and have severe impacts on your cumulative investment returns. The inability of most individual investors and their advisors to protect against market downside variation (draw down) is obfuscated with the marketing of long term average market return statistics and assertions about the risk-reduction value of diversification. The Dalbar report seems to confirm that most advisors and their clients lack viable methods for profitably allocating among stocks, bonds, sectors or geographies over time. Or maybe advisors do have workable methods, but must defer to their client's emotional reallocation choices in order to maintain relationships.

The average person is in specific funds for less than 4 years, largely through their companies 401K plans. When they change jobs they need to move their money into their next company’s plan, which has different fund choices. Or, outside 401K plans, people just change advisors every so often for a variety of reasons. People are sold using the average rate of return charts that seem to indicate constant upward movements.

There are two points you need to remember.

  1. Average returns over selected historical time periods can be very misleading. If you don’t have a good indication of the future direction of the market in which you have invested, or a very long-term investment horizon, buy and hold investing can be very risky. Your cumulative return during your remaining investment period is all that matters.

  2. Timing is everything. While poor timing depresses the investment returns of the average investor, effective trend following can enhance returns.

Important Disclosure regarding the example trend-following approach:

Returns are shown before fees and are total returns (dividends and price changes). Returns are not the result of real trading or the performance of Trendhaven, but historical model trade dates applied to the indicated high-yield bond fund and The Vanguard Federal Money Market Fund, applied to the same period as the Dalbar study. Results may not reflect the impact that economic and market factors might have had on an advisor’s decision making in managing client assets, or the impact of fund selections. The high-yield trend following model has been modified periodically to maintain robustness. Past indicative performance is not a guarantee of future returns.