Client Letter – Q2 2007

It’s easy to see what long-term stock market investors earn—just look at the averages, right?  Maybe not, according to some new research by Ilia Dichev at the University of Michigan.  From Jan. 1926 through this past April the Standard & Poor’s 500 Index grew at an annualized pace of 10.45%. But Dichev’s research on investor cash flows into and out of the markets indicate that the average investor earned less than that due to bad timing.  His investigation concluded that investors earned 1.3 percentage points less than did stocks on the New York Stock Exchange and a whopping 5.3 percentage points less than did stocks on the NASDAQ.  “This study provides comprehensive evidence that stock investors’ actual returns are considerably lower than those from passive holdings and from those documented in the existing literature on historical stock returns,” he wrote.

Why do investors apparently underperform the markets?  “The actual returns of investors are determined not only by the returns on the securities they hold but also by the timing and magnitude of their capital flows into and out of these securities,” Dichev wrote.  Rather than look at historical market returns alone, he measured “dollar-weighted” returns, that is, he gave specific weights to each year’s returns based on the total dollars investors put into the market that year.  This weighting more closely approximates a real investor’s actual portfolio returns.

Here is his simple example of how this works: An investor buys 100 shares of a stock at $10 a share.  The price goes up and he makes a second investment of 100 shares at $20 a share.  Finally, the stock price goes back down to $10 a share, and the investor sells out. No dividends have been paid.  The average return on the stock over the whole period is 0: it started at $10 and ended at $10.  But the investor’s return is much less.  He invested a total of $3,000, but ended up selling for $2,000.  His dollar-weighted return is a loss of 26.8%.

Dichev replicated these results on a market wide scale, finding that investors’ actual returns appear to regularly fall short of the market’s returns, implying “that capital flows tend to occur at the ‘wrong time,’ i.e., investor capital tends to flow into the stock market after superior past returns and before poor future returns, and tends to flow out of the market following poor past returns and before superior future returns.”  The translation is simple: investors as a group suffer from bad timing due to their penchant for chasing hot markets and getting scared by stock declines.  Dichev notes that his study echoes others that show the actual returns of mutual fund investors lag the returns of the funds themselves.

His study tells investors that “passive investment strategies are likely to do well because they avoid both transaction costs and the negative effects of timing,” he writes.  For instance, had an investor been able to buy an S&P 500 Index fund in 1926 and held it through 2007, his real return would have been about 10.4%, minus the fund’s small operating costs.

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About Christopher Jones

Christopher Jones is the Founder and President of Sparrow Wealth Management, a fee-only financial planning and investment management firm. Before entering the investment field, Chris was a management consultant for Deloitte Monitor. He graduated summa cum laude from Brigham Young University with a B.S. in Economics and a minor in Business Management.