Why Individual Investors Underperform Institutional Investors
Individual investor underperformance is typically caused by conflicted and/or bad advice.
Individual investors realized investor returns are awful. The reasons start with poor financial planning and work outward from there.
Spinning Gold into Straw
Every year, Dalbar studies the realized returns of investors in equity and fixed income mutual funds. Every year they find the same thing: investors dramatically underperform the benchmarks, across every time-period, from 12 months to 30 years.For example, over the 30-year period ending December 31, 2015, equity mutual fund investors received, on average, an annualized return of 3.66 percent. Over the same time-period the benchmark index returned an annualized 10.35 percent. These investors realized about 35 percent of the benchmark return which was available to them at virtually no cost. To put it another way, the typical investor took equity risk and got roughly half of a fixed-income return. Over time, these differences lead to massively disparate amounts of asset growth. I will put them in comparison using the case of an ultra-high net worth investor in Manhattan with $10 million in investable assets. If this investor earned the typical realized annual equity mutual fund return of 3.66 percent over a 30-year period, their assets would have grown to $29.4 million.The same investor earning the 10.35 percent index return over the same 30 years would have amassed $191.9 million. That’s 6.5 times the terminal value of the compounded realized return.Do I have your attention now?
Why do Individual Investors Perform Poorly?
The reasons are manifold. However, I believe the key drivers of underperformance can be reduced to a few simple factors, the most prominent being conflicted and/or bad advice. Conflicts exist where there are financial incentives to act in the advisor’s best interest instead of the clients. Bad advice is not just the selection of bad investments (although that is frequently a problem), but the provision of poor investment planning, processes, and management.In my experience, bad advice takes many forms, including:
- Lack of a written Investment Policy Statement (“IPS”);
- Not following the IPS;
- Poor risk tolerance profiling (including conflating the ability to take risk with the willingness to take risk, which I have written about here);
- Failures of cash flow planning (in particular, having to fund cash flow needs from sales of long-term investments);
- High fees, which are a certain destroyer of long-term returns;
- Use of complex Wall Street products such as variable annuities, structured products, and other investments created and packaged by brokerage and insurance firms;
- Pseudo-diversification, such as the purchase of multiple equity mutual funds with various size and style characteristics that turn out to be perfectly correlated in a downturn;
- Behavioral biases (by both advisors and their clients).
Private client advisors that fail in these regards are subtracting value. For ultra-high net worth investors, the accumulated costs of these failures can amount to hundreds of millions of dollars in lost growth over time.
Institutional Investors Don’t Have These Problems. Why Not?
Because they do the opposite of what individual investors do, including:
- Treating investing as a process and following the process;
- Spending significant time, energy, and thought on their IPS, and then following it closely;
- Knowing exactly how much risk they want to take, where they want to take it, and sticking to those choices;
- Reducing fees at every opportunity;
- Benchmarking managers and holding them accountable;
- Planning for cash flow needs in advance, and matching liabilities with assets to fund them.
Most importantly, institutional investors have fiduciaries guiding their investments. These fiduciaries are required, by law, to put the interests of the investor first and are bound by duties of loyalty and utmost good faith and fair dealing, among others, to the investor. It is hard to overstate the importance of getting fiduciary advice on investments. While fiduciary advice does not guarantee superior investment returns, or the avoidance of losses, it should eliminate the conflicts of interest that lead to the type of extreme underperformance reported in the Dalbar studies. Eliminating conflicts goes a long way to eliminating the impediments to successful long-term investing.In my next post, I’ll discuss how ultra-high net worth investors and families can invest like high-performing institutions.
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 See the annual Dalbar Quantitative Analysis of Investor Behavior; Available at: https://www.dalbar.com/QAIB/Index; Accessed May 4, 2018.
 Dalbar 22nd Annual Quantified Analysis of Investor Behavior; 2016; Available at: http://www.northstarfinancial.com/files/6314/6523/9571/2016_DALBAR_Advisor_Edition.pdf; Accessed May 4, 2018; 5.
 The Vanguard S&P 500 Index ETF (VOO) has an expense ratio of 4 basis points. Source: Bloomberg.
 See Supra Note 2. The fixed income return was 6.73 over the same 30-year period.
 See, for instance, An Investment Adviser’s Fiduciary Duty; Lorna A. Schnase; August 1, 2010; Available at: http://www.thefiduciaryinstitute.org/wp-content/uploads/2013/02/lornaschnaseFiduciary-Duty-Paper.pdf; Accessed May 7, 2018.