Reviewed and Updated January 2021
INVESTOR RETURNS VERSUS INVESTMENT RETURNS-Abstract: This article examines the surprisingly large performance gap between investment returns and the returns investors receive from financial markets.
Several articles on our website present historical investment returns and volatility for globally diversified DFA portfolios, various asset classes for specific periods of time and very long term research by Dimson et al., DFA and others regarding financial market returns. Virtual libraries full of research exist on past fund or manager or asset class returns but relatively little research has been done or is presented to investors on what returns real investors might reasonably expect to receive in their real-time portfolios. Investors receive returns based on their actual portfolios, not hypothetical returns based on what they might have received for some pre-selected time period with no deposits or withdrawals. Typically, investor returns lag hypothetical market returns substantially for three major reasons.
First, investment returns vary substantially depending upon the time frame sampled and are not predictable with statistical confidence except for time frames in decades. Investors cannot be certain they will capture the stream of long term returns in the asset classes they are invested in for the time frames they are invested in them. Shorter term returns do not necessarily reflect what can be expected from longer term returns. Often, passive and index portfolios are presented to investors as if average long term returns and volatilities are more or less constants that occur almost every year, change little over time and can be expected to do so in the future. This is decidedly not so.
Asset classes may underperform and outperform for very long time frames. One dramatic example of asset class underperformance would be the 1929 to 1932 collapse in US equities where the Dow declined by 89%. An investor purchasing equities at the 1929 equity market top would have required 25 years to break even on the Dow Industrial price (not including dividends). Other examples would be the strong outperformance of foreign equity markets versus US equity markets from 2000 through 2010, approximately doubling in price, while US markets merely broke even for that period or gold's dramatic outperformance of the S&P 500 from 2000 through 2018, a 458% gain versus the S&P's 146.6% gain, or 30 year US Treasury bond returns matching the S&P 500 return with dividends reinvested for the 30 year period between 1982 and 2011.
Second, real investors in real portfolios may not stay invested long enough to capture probable long term returns. Investor returns may differ from investment returns in that investors may plan to remain invested over very long time frames but then other things happen in life that requires money. Money flows into investment accounts and also out of them. Children may need to be loaned money for a home purchase. A new business may need to be funded. A second home may require additional funds. Divorces occur and require the separation of assets. A need for income may develop during retirement and allocations may need to be shifted. Investors may panic when markets drop more than they expect and sell at the worst possible time. There are many reasons long term portfolios don't end up being long term and the result is the sale of assets which were intended to capture long term returns but weren't invested long term. The result may be a dramatic underperformance versus long term market returns.
Third, ongoing annual costs involved in investing may substantially reduce returns. Advisory costs for managing accounts typically run from 0.5% to 1.5% with robo-advisor computer programs around 0.35%. EAM's typical client is paying under 0.1% annually for our management fee and we are full service and available whenever required. If mutual fund fees or outside manager fees are added in on top of advisory fees then investment management fees can become layered and in some large brokerage firms total client fees may be 2% or higher. In actively managed funds within taxable accounts high position turnover rates from trading may result in taxes costing more than returns deliver.
EAM has long emphasized minimizing costs involved when employing any investment strategy. Extensive research indicates that reasonable return expectations are far lower than Wall Street and the financial industry typically imply if not present in carefully selected data. Estimates from Fama Sr., Nobel laureate and a key research source for DFA, and Dimson et al with a large academic research team and data covering 25 countries and 118 years largely agree on probable forward investment asset class returns. Real returns in a globally diversified equity portfolio with a value/small cap tilt should be expected to be about 5% annually, in fixed income in short and intermediate bonds about 1% to 1.5% annually and in cash and cash equivalents like 3-month US Treasury bills, about 0.5% annually. These returns are very likely far lower than what most investors expect and do not include any of the investment costs noted above.
If we use these long term return estimates, a well diversified 60% equity/40% fixed income portfolio might be expected to return .6x5% + .4x1.5% or 3.6% annually. Thus, a 0.5% management fee would consume about 0.5%/3.6% or about 14% of returns. A 1% management fee would consume about 28% of returns and a 1.25% fee would consume 34.7% of returns. In addition to advisor costs if an advisor is recommending mutual funds the annual expense ratios of the funds must be added on to costs. Even the lowest cost passive and index funds, let's say at an overall portfolio cost of 0.3% annually in a full diversified 60% equity/40% fixed portfolio with Vanguard and DFA funds, will add another 8.3% annually to investor expenses. It's the investor's money that takes the risk but the advisor and/or manager takes a substantial percentage of the return whether the investor makes money or not.
What does the very small body of research on real investor returns in real investor accounts show? Research suggests that real investor returns are not just a little but are far below investment asset class or index returns. Dalbar gathers data on real investor returns in real portfolios. In 2016 Dalbar reported that the average investor in all US equity funds earned 3.7% annually over the last 30 years, a period in which the S&P 500 index returned 11.1% annually. Retail investors underperformed the S&P index by a very large 7.4% annually. Across all assets investors underperformed by 4.3% annually. Money flowing into and out of positions reduced returns and most investors chose active funds which underperformed indexes by 1% annually or more on average. Dalbar says the biggest factor in investor underperformance is that investors chase bull market returns up in price then dump positions after bear markets have caused too painful a decline in equity prices - greed, then fear. US retail investor participation in US equity markets has tended to oscillate between roughly 15% in bear markets to 55% in bull markets, a clear confirmation of this trend. The "behavior gap" measures the loss that the average investor incurs as a result of emotional responses to market conditions. Several academics have studied that gap and estimate a lag between 1.37% and 4.30% per annum. Disputes about proper measurement methodology and Dalbar's methodology exist yet it's clear that real investors underperform hypothetical fund or manager returns substantially whatever that percentage is.
How can an investor seek to minimize the underperformance of their real time portfolios versus returns in real markets? First, keep management costs as low as possible. EAM has long championed a very low fixed annual fee and makes use of very low cost passive and index funds. Second, allocate portfolios so they are appropriate and fitting for the time frame of your investments. Generally, that time frame should be considered 10 years minimum for equities and 15 years is definitely better. For fixed income we recommend that the time frame for the investing money be at least 2 to 3 years longer than the average maturity of bonds in the portfolio. And finally, as best you can, assess your worst case acceptable overall portfolio decline. This is critical and it should be stated as a percentage; e.g. -25% of total portfolio value. Passive and index portfolios only work well if investors can hold through bad times and well as good. EAM provides our clients with quarterly estimates of how much their portfolio could decline in a worst case and uses recent asset class declines in 2008-2009 as benchmarks. Of course, declines could be worse than 2008.