Update to Article 4.1 on Fear and Greed – Problems with the DALBAR Studies

In previous versions of Article 4.1 on Fear and Greed I used information from the company DALBAR that issues an annual report on investor behavior.  However, I recently ran across a March 6, 2017 article by Wade D. Pfau warning that DALBAR’s math is wrong.  I reference Wade Pfau’s work quite a bit in other articles on this website, and I very much respect his research and articles because of the level of quantification and clear attention to detail.   In summary, Pfau indicates that DALBAR incorrectly calculates dollar-cost-averaged returns for individual investors as shown in this graph.

You get some sense from this graph that the DALBAR method substantially under estimates dollar-cost-averaged results.  So, when this method is applied to individual investors, their results are assumed to be correspondingly low, regardless of any behavioral issues with their buying and selling practices.  As a result, I revised Article 4.1 to cite instead a review by Vanguard using a Morningstar study for the differences between individual investor returns and the returns of the funds themselves.  The Vanguard review provides much smaller differences between individual investor and fund performance as compared the large individual investor under-performance reported by DALBAR.

This is a good example of using the principles of rationality and empiricism that underlie a mindful investing approach as discussed in Article 2.  A mindful approach focuses on using empirical data and our own reasoning wherever possible.  We can’t always assume the work of others is right, even if it appears to come from an authoritative and unbiased source such as DALBAR.  It seems unlikely that DALBAR purposely underestimated individual investor performance, but nonetheless, it appears their information was at least partially incorrect.

DALBAR President Louis Harvey commented on Pfau’s article, but interestingly, he does not challenge the fundamental math issues presented by Pfau.  Instead, Harvey resorts to talking about the “utter impudence” of Pfau’s article and making a rather vague clarification that the DALBAR method calculates returns that investors “recognize as returns, not what the investments produce”.  Aren’t we always interested in what investments actually produce as opposed to what an investor “recognizes” as his or her returns?  Isn’t the first an objective measure and the second just a subjective self-assessment that is itself potentially laden with confounding emotional content?  Harvey’s response is troubling to me because it sounds like the classic dissembling of a large organization caught in a serious mistake and not willing to admit or correct it.  There may be more to report on this back and forth later, and I will post about it as developments occur.

Further, this episode highlights the dangers of “confirmation bias” as discussed in Article 5.1.  It’s all too easy to fool ourselves into believing what we want or what we think the “right” answer should be.  When I was developing Article 4.1, I purposefully used the DALBAR study, as opposed to some of the other ones available, because I noticed that the DALBAR results showed much poorer returns by individual investors.  And such a large under performance seemed to better support my contention that emotions drive investing for most people, which results in substantial investing mistakes.  I even wondered at the time why these various studies had such disparate results, but I deferred to the apparently authoritative presentation by DALBAR as well as the fact that many others were also citing the DALBAR work at major websites like Market Watch.

However, I have not had to revise the main points of Article 4.1 regarding emotions and how they impact individual investor performance.  Article 4.1 still correctly presents that individual investor performance lags that of their underlying funds, but that performance is not quite as bad as I originally contended.  Live and learn.



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