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Sorry, Wrong Numbers

Investment professionals love to talk about how clueless individual investors are. We're all doomed to poverty, they'd have you believe, without their highly compensated hand-holding.

But often the pros are the ones who fail to do the math.

Case in point: A new report from Dalbar, a Boston-based financial-services research firm, shows the returns of the average stock fund investor lagging far behind the stock market.

The Dalbar study finds that the average fund investor earned a cumulative return of just 141% from 1984 through 2000. That was a period when Standard and Poor's 500-stock index returned 1,201%.

On an annualized basis, the S&P 500 returned 16%, but the average investor earned only 5%. That's pretty pitiful when you consider that money market funds earned an annualized 6% over those same 17 years.

Pointing fingers

The study blames market timing for investors' woeful returns. "The low cumulative earned by investors over the long term demonstrate the lack of success investors have at timing the market," says the study, which Dalbar has been releasing annually for a number of years.

"Mutual fund investors run after the crowd ... always running late," chortled Steven Leuthold in his monthly research report, which is highly respected in the investment community.

And Barron's columnist Alan Abelson wrote: "During the biggest and longest bull market ever enjoyed by investing man, the only place the average equity fund investor could have put his money and gotten less back for it was gold and Las Vegas."

How the numbers lie

There's just one problem. The study's methodology is hopelessly flawed. At least that's what I concluded after a long interview with Louis Harvey, Dalbar's president.

Here's what the study does to figure the average investor's return. Using figures tracked by the Investment Company Institute, the study starts with the money invested in stock funds the first trading day of 1984. It credits every dollar invested on that day and every subsequent day with the same return as the S&P 500.

Here's the rub. To get the full return of the S&P 500, using Dalbar's methodology, every investor would have had to invest at the start of 1984 all the money he or she had invested at the end of 2000.

Look at it in microcosm. Suppose you’re a 20-year-old investor. You make your first stock fund investment in January 2000 and stay invested all year. The S&P lost 9% that year, so the study concludes that over the 17 years ending with 2000 you lost 9%. That, of course, makes no sense. In essence, though, the study pretends that money you invested in 1985, 1986 and every succeeding year was actually invested in 1984.

Only $71 billion was invested in stock funds at the start of 1984. Some $3.9 trillion was invested by the end of 2000. The reason for the growth in the amount of money invested is that people had much less to invest in stock funds in 1984 than they did at the end of 2000.

I've had money invested from my paycheck into stock funds pretty much every month since January 1984. I didn't have a fraction of what I have now in January 1984. There's no way I could have had it all invested in stock funds since 1984.

By averaging the returns of all the dollars invested over all 17 years, Dalbar comes up with its badly skewed results.

Finding the truth

Harvey says he doesn't know of any other way the study could have been constructed. "We can't identify which money has been in money market funds and then gets transferred into stock funds and which money is new money that goes straight into stock funds and stays there," he says.

I've been fascinated for years with what average stock fund investors make in the market. Although the actual returns for individual investors are elusive, what is crystal clear is that the average stock fund has lagged the S&P 500 by about two percentage points over the past 15 years. And those are returns produced by professionals.

It’s hard, perhaps impossible, to do the research accurately. That’s certainly no excuse for doing it badly. Until it can do it right, Dalbar ought to stop publishing its annual study.

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