Investors Do Not Underperform their Investments

DALBAR’s response to this article appears at the end of this article.

For 23 years DALBAR, Inc. has been publishing a research report reaching the conclusion, year after year, that investors underperform the investment vehicles that they invest in due to “poor investor decision making.” Wade Pfau recently discovered, however, that this conclusion is the result of a serious calculation error. Now, using Pfau’s results, I will prove that the evidence actually shows that investors do not underperform their investments.

I will first explain DALBAR’s error and then show, using two examples, how serious the error is. Second, I will describe the conventional wisdom that DALBAR’s error created, and how deeply entrenched it is. Third, I will explain why this received wisdom should have been the subject of skepticism in the first place. Fourth, I will show why Morningstar’s apparent confirmation of the conventional wisdom is mistaken. Finally, I will discuss another interpretation of poor investment decision making, and what it may mean.

DALBAR’s error

A little over a year ago, I sent an email to DALBAR asking for documentation about how their “investor return” is calculated. A DALBAR representative named Cory Clark sent back a two-page pdf file titled, “QAIB Methodology_2016.” I have since discovered that these same two pages are also included in DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) report, under the heading “Investor Return Calculation: An Example.”

These two pages provide a very simple description of a calculation in six steps: (1) compute monthly change in assets; (2) compute change in market value; (3) calculate totals for period (summing the months); (4) determine cost basis; (5) calculate investor return percentage; and (6) find annualized rate of return.

I thought that this write-up was much too simple and was obviously not the whole specification of their calculation methodology. So I wrote back to Clark asking if he could provide me with more precise formulas. He replied, “This is the most detailed description that is available to the public. Anything beyond what is in this document we consider proprietary in nature.”

I am always wary of “proprietary” calculations; therefore, this just raised my level of suspicion. But I did not pursue the matter further at the time.

Then, in March of this year, Pfau published his article in which he reverse-engineered DALBAR’s calculation, based on the results in a section of their QAIB report titled “Systematic Investing.”

Soon after, I realized that the calculation that Pfau discovered DALBAR was using was actually the same as the calculation in their simple two-page write-up. Nobody with any knowledge, however, would believe they were really using that formula, because it is so far off base.

The fatal flaw in the formula lies in step 5, “Calculated Investor Return Percentage.” This step is described as follows: “Dividing the investor return dollars calculated in Step 3 by the cost basis in Step 4 give the total investor return percentage.”

In other words, the sum of market changes in assets is divided by the sum of the cost basis of those assets to get investor return.