Asset-Allocation Funds Can Curb Market Timing, Leading to Better Returns  

The 2007 report found that while the past 20 years have been a boon to the mutual-fund industry, the average investor has earned only a fraction of the market's results. That's because mutual-fund performance is based on an investment held throughout a specific time period -- one, three, five, 10 years, etc. -- but investors frequently don't hold the funds for the entire period. Instead, they pour in cash as markets rise and start a selling frenzy after a decline. In addition, new funds, funds that surge in popularity and funds that close, may cause investors to switch or withdraw their money, which can lower returns, depending on when they occur.

Investors aren't great about timing the market. They're more likely to correctly guess the market's direction when it's rising, and to make mistakes after downturns, Dalbar found.

"These mistakes occur because investors are driven by the fear that the markets will not recover -- even though broad indices show that markets do indeed recover," the report says. Dalbar's advice: "If you don't know when to get out, it is better to stay in."

For a $10,000 investment over 20 years, dollar-cost averaging produced 40% higher returns than those earned by the average investor chasing returns, Dalbar found.

But asset-allocation funds -- which for the study's purposes include traditional balanced funds as well as target-date and lifecycle funds which automatically rebalance investors' portfolios -- can help temper those tendencies, said Mr. Harvey.

Investors are likely to hold asset-allocation funds substantially longer than either equity or fixed-income funds, the 20-year analysis showed. For example, based on the average investor's behavior in 2006, an investor in an asset-allocation fund would hold it for 5.2 years, while an investor in an equity fund would hold it for only 4.3 years, and an investor in a fixed-income fund would stay put for only 3.7 years, the study projected.

Mutual-fund investors can be their own worst enemies, but there is hope for curtailing their errant behavior, according to a study released yesterday.

The average mutual-fund investor earns significantly less than fund performance figures suggest, mostly because of their own impatient behavior. But asset-allocation funds can "create a comfort zone" to help protect investors from themselves, according to Dalbar Inc.'s 2007 Quantitative Analysis of Investor Behavior.

The Boston-based financial-services research firm examined real investor returns for equity, fixed-income and asset-allocation funds from January 1987 through December 2006.

The results could bode well for investors as the Pension Protection Act of 2006 is encouraging increased use of asset-allocation funds, such as target-date and lifecycle funds, particularly as defaults in defined-contribution plans.

"The two huge pieces of good news are the flow of assets into asset-allocation funds that are likely to be increasing -- it was the fastest-growing mutual-fund segment in 2006 -- and the other side of it is that equity investors are actually beginning to hold on," says Lou Harvey, president of Dalbar.

Since 1984, Dalbar has been measuring the effects of investor decisions to buy, sell and switch into and out of mutual funds. The conclusion has always been the same: Returns are far more dependent on investor behavior than on fund performance, and fund investors who hold their investments are more successful than those that time the market.

The Pension Protection Act will encourage retirement plans to automatically enroll investors and place their contributions in an established group of qualified default investments. Asset-allocation funds, such as target-date and lifecycle funds, are expected to be among the final list of qualified default investments, which has yet to be determined. The act will also encourage employers to increase automatic contribution levels over time.

"It was suggested that one of the reasons for that particular provision of qualified default investment alternatives in the Pension Protection Act was this fact that asset-allocation funds tended to improve investor behavior, and therefore would ultimately produce a more secure retirement," said Mr. Harvey. "You add the automatic features to that, which our study doesn't address, and I can see a dramatic improvement."

However, traditional performance measures show that asset-allocation funds severely underperform equity funds, the Dalbar report said. The average equity fund investor's 20-year annualized return jumped to 4.3% from 3.9% in 2006, while the average fixed-income fund investor's return was 1.7% and the average asset-allocation fund investor gained 3.7%, according to Dalbar.

Nevertheless, asset-allocation funds have prevented significant losses due to fear-based selling, the researcher says.

"Asset-allocation funds have been around for several decades, but have never enjoyed the spotlight," the report says. "Perhaps this is due to the way they are measured. This analysis shows that asset-allocation funds deliver what they promise -- lower risk, no switching and real returns for the investor."

Even in the face of one of the most severe market declines in history -- 2000 to 2002 -- retention in asset-allocation funds remained above 3.6 years, Dalbar found.

On another positive note, equity-fund retention rates held steady in 2006 at 4.3 years, the same as in 2005 and 2004 and the highest level since 1984, the study found. That greatly helped investors beat the performance of Standard & Poor's 500 index, Dalbar said.

"It is too early to speculate whether this improved behavior will continue, but it is encouraging to compare the recent investor actions against impulsive reactions around the 1987 crash and 2001 when retention reached record low levels," the report said.

Mr. Harvey said the equity fund retention may be "more of an indicator that investors are genuinely getting smarter and recognizing that the fact that the market goes down, as it did earlier this year, it does come back."