Why Do Individual Investors Underperform?

Barry Ritholtz posted a good video discussing whether mutual fund managers are skilled or not. I am not going to discuss the points made in that video, however, it did get me thinking about something. I have found that most mutual funds are closet index funds. That is, the vast majority of mutual funds are not engaged in any sort of strategic asset allocation that differentiates them sufficiently from highly correlated index funds. So, your average XYZ Large Cap fund will tend to have a 85%+ correlation to the S&P 500, but it will charge a much higher fee. Over time this will degrade performance since the mutual fund is basically picking 100-200 stocks inside of a highly correlated 500 stock index and charging you a recurring high fee over time. Vangaurd has shown on multuple occasions that it’s fees, not asset picking skill, that drives underperformance.

But what’s interesting about these mutual funds is that even though they can’t beat their index they do tend to beat the average individual investor. This has been well documented in research pieces (such as this one), but we also know it’s true thanks to investor surveys like the AAII asset allocation survey. Over the last 30 years AAII has maintained a record of individual investor asset allocations and over this period the average allocation has been:

• Stock/Stock Funds: 60%
• Bonds/Bond Funds: 16%
• Cash: 24%

What stands out there is the cash position. Of course, “cash” is a bit of a misnomer in a brokerage account because “cash” is usually just T-Bills. The kicker is, cash (or short-term bonds) has been a big drag on performance over the last 30 years.  The AAII investor with an average 24% cash position generated just a 8.4% annualized return relative to a 9.1% return for the average investor who invested that 24% in a bond aggregate (your standard 60/40). And keep in mind that this is before accounting for all the inefficiencies documented in the aforementioned research.

The interesting point here is that most professional money managers don’t hold a lot of cash at all times. The latest data from ICI showed that the average equity fund had just 3.5% cash.  Since bonds and stocks just about always beat cash over a 30 year period we know that the average individual investor with a 24% cash position MUST, by definition, do worse than even the closet indexing professionals.  This doesn’t mean the closet indexers are “skilled”. It just means they benefit from being in the game more. Basically, you can’t score if you aren’t even on the field and while closet indexing mutual funds are worse at scoring than their benchmark, they score more often than individuals because the individuals spend too much time out of the game.

So, the question is, why do individual investors tend to hold so much cash? I have a few guesses:

• Individuals are inherently short-term in their thinking because they know, intuitively, that their financial lives are a series of short-terms inside of a long-term.  This short-term perspective is a totally rational reaction to uncertain financial markets. A high cash balance provides the ultimate sense of certainty.  This is a silly perspective, however, because informed market participants know that financial asset market returns tend to become more predictable over longer periods of time. This does not mean, however, that we should necessarily apply the textbook idea of the “long-term” to our portfolios as this isn’t always consistent with our actual financial lives.
• This short-term thinking leads most investors to churn their accounts, pay high fees and pay high taxes. Again, it’s an attempt to create certainty in an inherently uncertain financial world. But the attempt to take control in the short-term generally results in lots of detrimental activity that hurts performance. I tend to be prefer a cyclical timeframe because it captures the best of both worlds – it can be tax and fee efficient without taking the irrational textbook “long-term” perspective.

This raises a more interesting question. Can this behavior be fixed?  I’m not so certain. In a world where we’re prone to thinking in the short-term the idea of “long-term” and even medium term investing is very difficult for most people to maintain.  But what it does show is that more investors need to be aware of their behavioral biases and understand the basic arithmetic of asset allocation.  You might not become a global macro asset allocation expert, but you can avoid making many of the short-term mistakes that lead to this disparity in performance.

Sources:

• ICI 2015 Factbook
• Trading Is Hazardous to Your Wealth:The Common Stock Investment Performanceof Individual Investors
• AAII Asset Allocation Survey
• Vanguard Principle 3: Minimize Costs