The field of Behavioral Finance has contributed greatly to our understanding of how investors make decisions. Unfortunately, many of the findings from this growing body of work have confirmed that investors routinely make sub-optimal decisions. What we know is that investors routinely chase performance; buying high and selling low. This cycle repeats itself to the point that the typical investor barely keeps up with inflation.
Consider that the annual study of investor behavior authored by Dalbar Inc., found that from 1995-2014 a 60/40 portfolio of U.S. stocks and bonds, as represented by the S&P 500 and the Barclays US Aggregate Bond Index, generated an annualized return of 8.7%, while the average investor earned just 2.5%, a mere 10 basis points above the rate of inflation over that period.
We can also look at mutual fund data to see this behavior in action. Morningstar calculates and reports the dollar-weighted returns earned by investors in each fund, along with the time-weighted returns reported by the funds themselves. The differences are substantial and persistent. Of the 44 mutual fund categories that we track, dollar-weighted investor returns were lower than the time-weighted returns for the fund category averages themselves between 93% and 100% of the time over 1-, 3-, 5-, 10- and 15-year periods ending in December 2015.
And before our readers make the assumption that this is simply reflective of the naivety of individual investors, take a look at Callan’s “2015 Alternative Investments Survey”. Within the Hedge Fund section of the report, Callan’s data indicates that 88% of institutional investors surveyed—those investors considered among the “sophisticated” crowd—will terminate a manager in two years or less for underperformance. Fully 57% of respondents put managers on an even shorter leash, dumping them if they didn’t meet expectations over a one-year period! And while we aren’t fans of the exclamation point—it’s far too overused and seems a tad bit unprofessional—we’ll add: one-year!!!!!! There is only one strategy we can think of that met performance expectations over every one-year period, and Mr. Madoff isn’t taking new money presently. Under this paradigm, it seems even God would quickly get fired.
We spend our days managing, and speaking with advisors about, alternative investment strategies. And it’s common during those conversations to hear something to the effect of “…but we’ve been burned multiple times by alternatives that didn’t work”. To which we have to ask, what exactly does “work” mean? What we find is that whether or not something “worked” is almost always a function of time frame, a very short time frame that is.
As 2016 has gotten off to a rocky (or rotten) start, it would be in our best interest to tout the fact that liquid alternatives are performing well year-to-date. But “year-to-date” is a whopping seven weeks old at this point. We should no more cheer good short-term performance than we should curse poor short-term performance. A thoughtfully designed, well diversified portfolio of traditional and alternative assets and strategies should get you through the good times and bad, but you’ve got to give it a chance to succeed.
