Dalbar’s Measure of Retail Investor Underperformance

Lately, I’ve heard a few references to Dalbar’s measure of how much retail investors underperform the investments they hold due to poor behaviour.  I suspect that if the people making these references understood how Dalbar calculates this measure, they’d be embarrassed at having mentioned it.  There can be legitimate academic debate about the best way to measure investor underperformance, but Dalbar’s simple method is just nonsense.

A simple example to illustrate the problem

Ann has invested in ABC fund for the past 5 years.  Her initial investment was $10,000.  Over the first 4 years, she left her investment alone and it grew 50% to $15,000.  Ann then got an inheritance of $20,000, which she put into ABC fund to give her a total of $35,000.  In the final year, ABC went up 6%.  Ann now has $37,100.

By any reasonable method of analyzing Ann’s investment behaviour, she exactly matched the performance of her fund.  She was always fully invested with the money she had available.  She never held back any funds waiting for a better entry point, and she never withdrew any money anticipating a market decline.

But let’s look at what happens when we apply Dalbar’s calculation method.  Over the 5 years, ABC fund produced a 50% total return over the first 4 years, and a 6% return in the last year.  The total return for the 5 years is then

(1 + .50) * (1 + .06) - 1 = 59%.

The compound average annual return for ABC fund is

(1 + .59) ^ (1/5) - 1 = 9.72%.

Ann invested a total of $30,000 over the 5 years.  Her total return is

$7100 / $30,000 = 23.67%

Her compound average annual return is

(1 + .2367) ^ (1/5) - 1 = 4.34%.

Ann’s annual underperformance is then

9.72% - 4.34% = 5.38%.

Apparently, Ann is a terrible investor.  According to Dalbar, Ann’s poor behaviour was in receiving her inheritance late in the 5-year period.  She should have invested the entire $30,000 5 years ago.  This is nonsense, of course, but that’s how Dalbar’s calculations work.

Telling advisors what they want to hear

To my knowledge, Dalbar doesn’t apply their methods to a single investor in this way.  They look at investors collectively across a set of funds.  However, the same problem illustrated above exists.  During any period of net inflows, investors are blamed for the returns these inflows missed at the beginning of the measurement period.  Investors are blamed for “poor timing” because they didn’t invest the money earlier.  The fact that most of them were unable to invest before they had earned the money is not considered a valid excuse.

With this calculation method, it’s possible to make retail investors look as bad as you want them to look by being selective about the measurement period and the set of funds.  Sadly, many investment advisors accept stories about retail investor underperformance uncritically, because it tells them what they want to hear.  The truth is that retail investors lose some money due to poor behaviour, but not as much as Dalbar made it out to be over the years.