A Simple Explanation for DALBAR’s Misleading Results

The following is an excerpt from The 3 Simple Rules of Investing: Why Everything You’ve Heard about Investing Is Wrong – and What to Do Instead by Michael Edesess, Kwok L. Tsui, Carol Fabbri, and George Peacock.  It is taken from part II, “Investing’s 7 Deadly Temptations,” deadly temptation #2: “Trust It All to Our Expertise.”
For a number of years, a company named DALBAR has been publishing a report called the “Quantitative Analysis of Investor Behavior” (QAIB). The QAIB purports to show that investors make bad decisions and, as a result, their investments underperform the market by several percentage points. This material is a godsend to financial advisors because it implies that investors need to hire an expensive financial advisor to help them. It’s also been a godsend to DALBAR. It has captured headlines for years, perpetuating the myth that individual investors invest poorly, and therefore they do much worse than the market average.

Financial advisors have been purchasing the DALBAR report in droves. The sample version of the 2013 report begins with an introduction titled “The Disease of Investor Underperformance.” In the lower-right corner of every page of the sample version is an entry that says “Compliments from Advisor Name.” In other words, “Your name, Ms. or Mr. Advisor, could go here if you purchase from DALBAR the right to distribute the report to your clients and prospects.” For $1,000, advisors can buy the right to make unlimited copies for their financial advisory clients and prospects. That $1,000 is well worth it because this report will show people how badly they’ll do if they don’t have “expert” help.

There’s just one thing: the DALBAR result is wrong.

First, let’s consider: If some group of investors underperforms the market, then there must be another group that outperforms the market. That’s simply logical, because between them all investors are the market. So to make things add up, if some investors – say, the individual investors who are the main subject of the DALBAR study – systematically underperform the market, then there must be some other group that systematically outperforms the market. The trouble is, there is no evidence of any such group. One would think that if individual investors underperform the market, then it must be professional investors who outperform the market.

But they don’t. Study after study after study shows that professional investors do not, on average and in aggregate, outperform the market. So it simply can’t be true that individual investors as a group systematically underperform the market.

So why does the DALBAR study seem to show that they do? It’s because of their methodology, and the way they calculate investor performance.