2011 QAIB

Quantitative Analysis
of Investor Behavior

Helping Investors
change behavior to
capture Alpha

Prepared by
DALBAR, Inc.
Research & Communications
Division

March 2011

Federal Reserve Plaza

600 Atlantic Ave, FL 30
Boston, MA 02210
617.723.6400
www.dalbar.com
Table of Contents

HELPING INVESTORS SEE THE ALPHA AND OMEGA OF INVESTING ................................................... 3

INVESTOR RETURNS ......................................................................................................................... 7
INVESTOR BEHAVIORS CONTINUE TO FALL PREY TO MARKET FORCES ........................................... 10
QAIB THROUGH THE YEARS ........................................................................................................... 13
SYSTEMATIC INVESTING - CHANGES OCCURRING .......................................................................... 14
DESPERATELY SEEKING ALPHAAND HOW TO CAPTURE MORE .................................................... 18
GLOSSARY ...................................................................................................................................... 22
APPENDICES ................................................................................................................................... 24
YEAR-BY-YEAR INVESTOR RETURNS ............................................................................................... 25
INVESTOR RETURN CALCULATION: AN EXAMPLE ........................................................................... 26
RIGHTS OF USAGE AND SOURCING INFORMATION ........................................................................ 28

Page | 2
Helping investors see the Alpha and Omega of Investing
2010 saw a turnaround in the US Stock Market. With the S&P 500 ending the year up
15.06%, which along with positive news stories about the US stock market at year end,
helped investors to resume more aggressive investing. In spite of the recovery of the stock
market a general unease continues as sectors of the economy struggle to gain solid footing.
The potential risks that have been plaguing the market for the last few years continued:

historically high levels of unemployment

the soft US housing market
fears of a double dip recession
a deep concern about deficits in federal, state and local governments
$14 trillion federal debt

It continued to be a struggle to help investors protect and grow portfolios by taking

advantage of the behavior of investments and using the available time horizons. 2010 was a
year filled with events that challenged investors to keep their eyes focused on fundamentals
of their investments, including the time and nature of those investments. 2010 saw volatility
or other market forces in almost every month. Events that were likely to have affected
investor behavior were:

February: Worries about Europes debt crisis specifically, Greece

March: Massive health care bill signed into law
April: The deadly BP offshore oil rig explosion
May: The Flash Crash
July: The Wall Street reform bill is signed into law
November: Republicans win control of the House of Representatives, and the
Federal Reserve introduces second Quantitative Easing Program
December: $858 billion tax increase averted at the last minute, and the Dow,
S&P 500 and Nasdaq all end the year in positive territory

As of the writing of this report, the earthquake, the devastating tsunami and the growing
nuclear crisis in Japan, represent the latest news that has impacted the US and World
financial markets and will undoubtedly challenge investors to maintain a prudent investment
strategy.

This report continues to illustrate how more in depth When investor behavior is
application of investor behavior is required, to keep the anticipated and investment
investor invested along this uncertain road. When investor plans are developed and
behavior is anticipated and investment plans are developed maintained, investors will
and maintained, investors will capitalize on the alpha capitalize on the strategies
created by the strategies and tactics of financial advisors and tactics of financial
and portfolio managers. Investors must be guided to rely advisors and portfolio
more on the probabilities of history than the possibilities of managers.
emotion - this seems possible but is complex.

DALBAR found in the 2010 Quantitative Analysis of Investor Behavior (QAIB), that the
average equity fund investor has increased retention rates from 3.22 years in 2009 to 3.27
years for 2010. This helped investors take advantage of the positive returns of 2010.

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The increased retention has continued year over year, but unfortunately is still far short of
the ideal needed to take advantage of market performance. The psychological factors that
batter away at average investor returns remain dominant while the code to crack these
behaviors still remains elusive. Retention of investments for optimum periods is a major
reason that investor returns fall short of the potential.

Unlike trading strategies that are occasionally successful, investment strategies that give
weight to investment behaviors that have been observed over several decades continue to
offer the best basis for investors portfolio construction. Even more important than a
sound investment strategy are investors who are prepared to withstand the
temptations to overreact to short term events.

Key Findings for 2011

Investors who limit the time retention for investments erode the alpha created by
portfolio managers.
The average equity investor earned an annualized return that outpaced inflation for
both the twenty year and the one year time frames.
Fixed income and asset allocation investors continue to lose ground to inflation as
their investments lag the cost of living in all but the exceptional one-year time
frame.
All long term mutual funds continue to be held for less than five years.

About DALBAR, Inc.

DALBAR, Inc. is the financial communitys leading independent expert for evaluating, auditing
and rating business practices, customer performance, product quality and service. Launched
in 1976, DALBAR has earned the recognition for consistent and unbiased evaluations of
investment companies, registered investment advisers, insurance companies,
broker/dealers, retirement plan providers and financial professionals. DALBAR awards are
recognized as marks of excellence in the financial community.

About This Report: QAIB 2011

Since 1994, DALBARs QAIB has been measuring the effects of investor decisions to buy, sell
and switch into and out of mutual funds over both short- and long-term time frames. The
results consistently show that the average investor earns less in many cases, much less
than mutual fund performance reports would suggest.
The goal of QAIB is to continue to improve the performance of independent investors on the
one hand and of professional financial advisors on the other hand by incorporating the
factors that influence behavior that determines the outcome of investment or savings
strategies. QAIB offers guidance on how and where investor behaviors can be improved.

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QAIB 2011 examines real investor returns in equity, fixed income and asset allocation funds.
The analysis covers the 20-year period ended December 31, 2010, encompassing both the
drop at the turn of the millennium and the crash of 2008, plus the recovery periods of 2009
and 2010. This years report discusses the goal of investor alpha.
The report explains how investors and advisors adapt to changing market conditions and
produce investor alpha using investor behaviors, the psychological factors that drive them
and the knowledge of how investment classes have acted in the past.
The introduction of the concept of investor alpha continues with the tradition uncovered
when the study was first published in 1994 that no matter the state of the mutual fund
industry, boom or bust, the key findings remain consistent: Investment results are more
dependent on investor behavior than on fund performance. Mutual fund investors
who hold on to their investments are more successful than those who time the
market.

Report Highlights

Investor Returns The bottom line: how did investors return compared to broad market
indices?

Investor Behaviors Continue to Fall Prey to Market Forces A look at how investor
behavior affects that bottom line, and a discussion of why investors do what they do.

QAIB Through the Years This section compares the average investor returns and buy-
and-hold returns for each calendar twenty year period since 1998.

Systematic Investing - Changes Occurring This section shows the results for the
average investor in equity, fixed income or asset allocation mutual funds and the
hypothetical process of systematic investing.

Desperately Seeking ALPHAAND How to Capture More Introduces a behavior

based approach to maximize alpha for the retail investor.

Methodology
QAIB uses data from the Investment Company Institute (ICI), Standard & Poors and
Barclays Capital Index Products to compare mutual fund investor returns to an appropriate
set of benchmarks. Covering the period from January 1, 1991, to December 31, 2010, the
study utilizes mutual fund sales, redemptions and exchanges each month as the measure of
investor behavior. These behaviors reflect the average investor. Based on this behavior,
the analysis calculates the average investor return for various periods. These results are
then compared to the returns of respective indices.
A glossary of terms and examples of how the calculations are performed can be found in the
Appendices section of this report.

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The QAIB Benchmark and Rights of Usage

Investor returns, retention and other industry data presented in this report can be used as
benchmarks to assess investor performance in specific situations. Among other scenarios,
QAIB has been used to compare investor returns in individual mutual funds and variable
annuities, as well as for client bases and in retirement plans. Please see the Rights of
Usage section in the Appendices for more information and appropriate citation language.

For more information on creating a custom analysis or presentation using the

QAIB data and methodology, contact Stephanie Ptak at sptak@dalbar.com or
617-624-7134.

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Investor Returns
The 2011 QAIB report shows that equity and fixed income investors have underperformed
the broad indices over the 20 years ending in 2010. The one year 2010 return for the
average equity investor underperformed the S&P 500 by almost one and one half percent.
The fixed income investor underperformed the Barclays Aggregate Bond Index by over three
and one half percent. 1

QAIB found average annualized returns for all investor types, equity, fixed income and asset
allocation, exceeded the inflation rate for a ten year period. This was the first time this has
occurred in QAIB history. Unfortunately, this was caused by unusually low inflation rates in
2001, 2003. 2008 and 2010 and due less so to improved investor returns.

1
Average stock investor, average bond investor and average asset allocation investor performance results are
calculated using data supplied by the Investment Company Institute. Investor returns are represented by the
change in total mutual fund assets after excluding sales, redemptions and exchanges. This method of calculation
captures realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and
any other costs. After calculating investor returns in dollar terms, two percentages are calculated for the period
examined: Total investor return rate and annualized investor return rate. Total return rate is determined by
calculating the investor return dollars as a percentage of the net of the sales, redemptions and exchanges for each
period.

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The chart below shows that in all asset classes, the average investor continued to react to
negative news about the market. The year of 2008 illustrates this point. That year had one
of the worst market corrections with the S&P 500 falling -37.72%, the Barclay Aggregate
Index returning 5.24% and inflation at 1.5%. The proliferation of the 24/7/365 news
coverage that focused heavily on the negative market news in 2008 was undoubtably one
reason investors reacted poorly.

Strong returns in 2009 and 2010 have erased the 20, 10 and 5 year cumulative losses
created by the 2008 markets.

Annualized Investor Returns by Fund Type vs. Inflation

20-year 10-year 5-year 3-year 1-year

Equity 3.83% 1.55% 1.61% -4.21% 13.60%
Fixed Income 1.01% 0.77% 0.86% 0.33% 2.99%
Asset Allocation 2.56% 1.31% 0.96% -2.27% 9.34%
Inflation 2.57% 2.48% 2.46% 1.86% 1.48%

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Mutual fund firms are required by law to only advertise the results of buy and hold
investors, and use market indices to illustrate their added value. For example, the chart
below shows the return a 20-year buy-and-hold investor in the S&P 500 and the Barclays
Aggregate Bond Index would have earned on an annualized basis since 1991, compared to
inflation.

Benchmark Returns

20-year 10-year 5-year 3-year 1-year

S&P 500 9.14% 1.41% 2.29% -2.86% 15.06%
Barclays
Aggregate Bond 6.89% 5.84% 5.80% 5.90% 6.54%
Index

Equity mutual fund investors continue to outperform bond investors. To take full advantage
of any alpha created by portfolio management, investors need to remain invested and must
not step in and out of the market. Bond holders over the long-term will see fairly consistent
returns, which continue to support that a properly constructed investment portfolio should
take advantage of multiple asset classes, consistent with the investors timeframe and
comfort with risk.

Page | 9
Investor Behaviors Continue to Fall Prey to Market Forces
The following charts illustrate that investors continue to react to market movements and the
news. One of the most startling and ongoing facts is that at no point in time have average
investors remained invested for sufficiently long enough periods to derive the benefits of a
long-term investment strategy.

While we still see that investors will react to market corrections over the 20 years since
1991, since 2003 the reaction has been more muted. These charts show that
recommendations by many mutual fund companies to remain invested have had little effect
on what investors actually do. The result is that the alpha created by portfolio management
is lost to the average investor, who generally abandons investments at inopportune times,
often in response to bad news.

In 2010, as in years past, asset allocation fund investors have retention rates that are over
one year longer than equity or fixed income investors, which is a significant difference.

Retention Rates: Equity Funds

4.50
4.00
3.50
3.00
Years

2.50
2.00
1.50
1.00
0.50
0.00
91 992 993 994 995 996 997 998 999 000 001 002 003 004 005 006 007 008 009 010
19 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2 2

Page | 10
 Retetion Rates: Fixed Income Funds

4.50
4.00
3.50
3.00
Years

2.50
2.00
1.50
1.00
0.50
0.00
91

92

93

94

95

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20
The investors in asset allocation funds have historically held on to their funds for the longest
periods of time and this continues to be the case in 2010.

Retention Rates: Asset Allocation Funds

6.00
5.00
4.00
Years

3.00
2.00
1.00
0.00
91

92

93

94

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96

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Behavioral Finance Helps Explain Irrational Actions

The psychological factors of behavioral finance help explain why investors often make buy
and sell decisions that contradict the best investment practice. In order to correct the
behavior, advisors and others need to apply antidotes to the factors that drive the poor
choices that investors make:
Loss aversion: Expecting high returns with low risk
Narrow framing: Making decisions without considering all implications
Anchoring: Relating to familiar experiences, even when inappropriate
Mental accounting: Taking undue risk in one area and avoiding rational risk in others
Diversification: Seeking to reduce risk by simply using different sources, giving no
thought to how such sources interact
Herding: Copying the behavior of others even in the face of unfavorable outcomes
Regret: Treating errors of commission more seriously than errors of omission
Media response: Reacting to news without reasonable examination
Optimism: Believing that good things happen to me and bad things happen to
others

Page | 11
Guess Right Ratios Effect on Investors Alpha

DALBAR continues to analyze the investors decision making process for their purchases and
sales. This analysis, known as the Guess Right Ratio, examines fund inflows and outflows to
determine how often investors correctly anticipate the direction of the market.

DALBAR looks at the data to determine if an investor can correctly guess the timing of their
purchases or sales and what impact those decisions have on the returns earned by the
investor. The guess right ratio shows that poor timing and fear will impact and erode return
or alpha created by portfolio managers. Alpha is erased for investors that execute purchases
or sales in response to something other than a prudent investment decision, and are
frequently unsuccessful. Investors guess right when a net inflow is followed by a market
gain, or a net outflow is followed by a decline.

In general, investors make money when the Guess Right Ratio exceeds 50%.2 Over the 20-
year period ended December 31, 2010, the overall Guess Right Ratio was 67%. Analyzing
the chart below, we notice that investors made money 14 out of the 20 years represented.
During the six years when investors made poor decisions, correlates to trying times for
investors. As the markets have improved in 2009 and 2010, we notice that it is easier for
investors to make the right decision when markets are rising and their fear of loss is not the
major decision driver.

How Often Do Investors Guess Correctly?

100 92 $70,000
90 83 83 83
$60,000
Guess Right Ratio

(growth of $10k)
80 75 75
67 67 67 67 67 67 $50,000
70

S&P 500
(in %)

58 58
60 50 50 50 $40,000
50 42 42
40 $30,000
30 25
$20,000
20
$10,000
10
0 $0
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Guess Right Ratio S&P 500

The following chart further supports the findings of the Guess Right Ratio. It illustrates how
market inflows and outflows compare with monthly market returns.

Investor Fund Flows and Market Performance for the

5 Years Ended 12/31/10

1.00% 15.00%
Fund Flows as %

0.50% 10.00%
of total assets

Monthly Market Returns

5.00%
0.00%
0.00%
-0.50%
-5.00%
-1.00%
-10.00%
-1.50% -15.00%
-2.00% -20.00%
Jan 06 Jan 07 Jan 08 Jan 09 Jan 10

Fund Flows S&P 500

2
Please note that the Guess Right Ratio is not dollar weighted, so it cannot be used to measure returns.
Page | 12
QAIB Through the Years
This chart shows that investor returns continue to lag buy-and-hold returns significantly over
the long term. The gap has narrowed through the years. In 1999, the difference between
the long-term annualized average of the buy-and-hold investor (as represented by the S&P
500) and the average equity fund investor was 10.65%. In 2010, however, that gap shrunk
to less than half that amount, 5.31%.

Long-Term Returns (annualized, in percent)3

Average Equity
Year S&P 500 Difference
Fund Investor
1998 17.90 7.25 -10.65
1999 18.01 7.23 -10.78
2000 16.29 5.32 -10.97
2001 14.51 4.17 -10.34
2002 12.22 2.57 -9.65
2003 12.98 3.51 -9.47
2004 13.20 3.70 -9.50
2005 11.90 3.90 -8.00
2006 11.80 4.30 -7.50
2007 11.81 4.48 -7.33
2008 8.35 1.87 -6.48
2009 8.20 3.17 -5.03
2010 9.14 3.83 -5.31

It is believed that improving results from 1998 to 2010 were largely due to the fact that
investors who entered the markets in the 90s have now experienced multiple market
declines and recoveries and have learned from those experiences. They found that
remaining invested has, over the long term, produced positive results.

S&P 500 vs. Average Equity Fund Investor

20.00%

15.00%

10.00%

5.00%

0.00%
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

S&P 500 Average Equity Fund Investor

3
The original analyses began in 1984, so that between 1998 and 2002, the period covered was less than 20 years.
Since 2003, however, the long-term analysis has covered a 20-year time frame.
Page | 13
Systematic Investing - Changes Occurring

On the next three pages you will find charts that compare a hypothetical $10,000
investment made by an average investor in equity, fixed income or asset allocation mutual
funds and the results of the same hypothetical investment used in a process of systematic
investing over a comparable twenty year time horizon.

Findings

This is the first time in 17 years since the QAIB Report was first published that we
have observed the systematic equity investor failing to outperform the average
equity investor. (see charts, page 16);
Since the systematic equity investor failed to outperform the average equity investor
it does not mean that investors should abandon the concept of systematic investing.
It should however cause investors or the financial advisors that support them, to
seek new strategies to counteract investor behavior that loses alpha. (see charts,
page 16);
The average systematic fixed income investor did, however, outperform the average
fixed income investor over the twenty year period by earning over four times as
much. (see charts, page 17);

Page | 14
 Average Equity Fund Investor
1991 - 2010
$30,000
Average annual rate of return:
3.83%
$25,000 $11,217
Earned

$20,000

$15,000

$10,000 $10,000
Invested

$5,000

$0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

AppreciationAxis Title
Principal

Systematic Equity Investor

1991 - 2010
$25,000

Average annual rate of return: $10,296

3.60% Earned

$20,000

$15,000

$10,000
$10,000
Invested

$5,000

$0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Appreciation Principal

The systematic equity investor is represented by the S&P 500, an unmanaged index of common stock. Data
supplied by Standard & Poors. Indexes do not take into account the fees and expenses associated with investing,
and individuals cannot invest directly in any index. Past performance cannot guarantee future results. Systematic
investing involves continues investing in securities regardless of price levels. It cannot assure a profit or protect
against loss during declining markets. Past performance cannot guarantee future results.

Page | 15
 Average Fixed Income Fund Investor
1991 -2010
$14,000 $2,217
Average annualrate of return: Earned
1.01%
$12,000
$10,000
Invested

$10,000

$8,000

$6,000

$4,000

$2,000

$0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Appreciation Principal

Systematic Fixed Income Investor

1991 - 2010
$25,000

Average annualrate of return:

3.39% $9,490
Earned
$20,000

$15,000

$10,000
Invested

$10,000

$5,000

$0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Appreciation Principal

The systematic fixed income investor is represented by the Barclays Aggregate Bond Index. Past performance
cannot guarantee future results. Systematic investing involves continues investing in fixed income assets regardless
of price levels. It cannot assure a profit or protect against loss during declining markets. Past performance cannot
guarantee future results.

Page | 16
 Average Asset Allocation Fund Investor
1991 - 2010 $6,568
$18,000 Earned
Average annualrate of return:
2.56%
$16,000

$14,000

$12,000

$10,000

$10,000
$8,000 Invested

$6,000

$4,000

$2,000

$0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Appreciation Principal

Systematic Equity Investor

1991 - 2010
$25,000

Average annualrate of return: $10,296

3.60% Earned

$20,000

$15,000

$10,000
$10,000
Invested

$5,000

$0
Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan- Jan-
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

Appreciation Principal

The systematic equity investor is represented by the S&P 500, an unmanaged index of common stock. Data
supplied by Standard & Poors. Indexes do not take into account the fees and expenses associated with investing,
and individuals cannot invest directly in any index. Past performance cannot guarantee future results. Systematic
investing involves continues investing in securities regardless of price levels. It cannot assure a profit or protect
against loss during declining markets. Past performance cannot guarantee future results.

Page | 17
Desperately Seeking Alpha and How to Capture More
As this report has shown for the 17th time in as many years, mutual fund investors
consistently underperform the relevant index. The report also shows that most of this loss in
performance is due to psychological factors that translate into poor timing of their buys and
sells (investor behavior).

Portfolio managers expend enormous efforts determining what investments to make, the
right time to buy and the right time to sell so as to gain a few basis points of alpha, only to
see retail investors give up percentage points in returns by poor timing of their buys and
sells.

While this contradiction between the psychological drivers of investor behavior and prudent
investing continues to create enormous lost opportunities, some investors and some
advisors have been able to avoid the alpha robbing behavior. This has been achieved by a
better understanding and management of the psychological factors coupled with the
understanding of the investments being used. Unfortunately, simply providing education on
investor behavior and investment managers strategies have only had limited success.
This article presents an approach used only by a few to maximize the alpha of the retail
investor. While a buy and hold strategy prevents a loss of alpha, which would be a great
improvement for most investors, effective management of psychological factors and an
understanding of the behavior of investments being used, combine to produce positive
alpha.

What Is Investors Alpha?

Alpha is a measure of performance on a risk-adjusted basis. Alpha takes the volatility (price
risk) of a mutual fund and compares its risk-adjusted performance to a benchmark index.
The excess return of the fund relative to the return of the benchmark index is a fund's
alpha. Simply stated, alpha represents the value that a portfolio manager adds to or
subtracts from a fund's return.

Investors alpha is the value a retail investor adds or subtracts from the alpha delivered by
the portfolio manager. The return of the respective index is considered to be zero alpha so
any excess over the index is considered positive investor alpha.

Understanding the Behavior

Investors are driven to do the wrong thing by the psychological factors that overtake
rational decision-making.
1. Loss Aversion expecting to find high returns with low risk. Loss aversion causes
the investor to search for investments that dont exist and results in either taking no
action or later discovering that the selected investment fails to meet the
expectation. The effect is often selling the investment at an imprudent time and
losing alpha.
2. Narrow Framing making decisions without considering all implications. The
result is quick decision making with the consequence that facts are uncovered after

Page | 18
 inappropriate investments are made. Investors make precipitous investment
changes, which can lose alpha.
3. Anchoring relating to the familiar experiences, even when inappropriate.
Anchoring is a very powerful communication method but can mislead investors
unless it is used with caution. For example, investors can be misled about the
stability of an investment if analogies are used to represent stability. Analogies of
growth can also lead to unrealistic beliefs and expectations. Alpha can be lost by
selecting investments that cannot reasonably be expected to produce the expected
alpha.
4. Mental Accounting taking undue risk in one area and avoiding rational risk in
others. Used wisely, Mental Accounting can permit an investor to achieve high
alphas in one area while protecting assets for other purposes. Imprudent use of
Mental Accounting can be as damaging to alpha as any other psychological factor
since investors can be misled into inappropriate investments.
5. Diversification seeking to reduce risk, but simply using different sources. This
extremely valuable investment strategy can also be misused to create a false sense
of protection that results in alpha killing actions.
6. Herding copying the behavior of others even in the face of unfavorable
outcomes. Investors that go along with the crowd simply because there is a crowd
tend to avoid catastrophic errors but seldom achieve above average results. Alpha is
not achieved by Herding.
7. Regret treating errors of commission more seriously than errors of omission.
Investors who fear decision making lose alpha through inaction or reversals.
Inaction can prevent losses caused by poor decisions but is unlikely to produce
alpha.
8. Media Response tendency to react to news without reasonable examination.
Familiar media sources have become less reliable as they compete with newer,
faster and lower cost outlets. At the same time, new media outlets seldom have
very thorough authentication. This question of reliability raises the concern about
reacting to news.
9. Optimism belief that good things happen to me and bad things happen to others.
Optimistic investors hold on to investments after it becomes evident that losses are
not likely to be recovered. Holding on to poor investments is yet another way
psychological factors can reduce alpha.

Managing the Behavior

The alpha killing psychological factors described above must be curbed to produce desirable
results for alpha seeking investors. The key to curbing undesirable reactions is to introduce
a pause in the flow to assess the facts. During this pause the investor should evaluate if
he/she is succumbing to one or more of the nine psychological factors listed.

These factors are transformed into questions that will alert investors of potential
psychological traps. Interpreting the answers correctly and acting on them appropriately can
prevent alpha losing investment decisions. While all these questions will not apply to every
investor, at least one will. The questions listed here must be adapted to the specific situation
and represent the line of questioning and not necessarily language applicable to all
investors:

Page | 19
 1. Do you believe that an investment under consideration produces a return with little
risk? Are you aware of the risks?
2. Have you considered what it will mean to you to commit to this investment for ten
years if you should need the money?
3. The illustration that was used is not literal; do you see how it differs from real life
investing?
4. Do you have a specific purpose in mind for each investment portfolio that you own?
Do you know how much risk you are willing to take with each one?
5. Do you know whether you have the same underlying investment in different
portfolios? Does that mean that you have excessive exposure to that underlying
investment?
6. Have you heard from others that the investment under consideration is a good
one? How many people have recommended it? Would you consider these people to
be experts? Are the recommendations based on your personal situation?
7. Do you expect the value to decline the day after you make an investment? If the
value does decline, will you withdraw your funds?
8. Have you seen recent news reports or stories that relate to the investment under
consideration? Have those news reports made you more or less inclined to own the
investment under consideration?
9. Have you considered the changes that have occurred since your decision to make
the investment under consideration? Would it be wise to put some of the profits
you have made into a more secure investment?

Understanding the Investment Behaviors

Managing investor behavior is only one half of the solution to maximizing investors alpha.
The second half is the understanding of the investments themselves. The overarching
requirement is to understand and select the appropriate asset classes and the allocation
among classes. This requirement is the subject of a great deal of study and will not be dealt
with in this report, except to acknowledge that it is of paramount importance in investment
decision making.

The subject here is the differences in how various investments react to changing conditions.
This investment behavior applies to all asset classes and defines the action investors need
to take to maximize their alpha.
Investment behaviors fall into three broad categories based on who is expected to seek the
alpha. Any one investment may be a blend of these categories:
Investments that alone seek alpha portfolio managers have the flexibility to go in
and out of markets as conditions change in an attempt to outperform benchmarks.
The key determinant of this investment behavior is the ability to make significant
changes in the asset class mix in the portfolio.
Investments that seek zero alpha these investments have definitive styles which
remain consistent, regardless of market conditions. The expectation is that investors
will make changes into and out of these investments to maximize their alpha.

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 Investments that seek beta portfolio managers seek to minimize losses in down
markets at the expense of higher returns in up markets. This type of investment is
not appropriate for investors seeking alpha.

Maximizing Investors Alpha

Success in maximizing alpha requires overcoming the psychological factors, creating the
proper asset allocation and ongoing review of the investments.

For investments that seek their own alpha and have the flexibility to react to market
conditions, the investor need only select and monitor results and how effectively the
investments deal with changing market conditions. The investor simply buys and holds until
personal needs change, leaving the adaptation to changing conditions to the portfolio
manager.

Investments that seek zero alpha require the investor or advisor to change investments in
response to market conditions. Doing this correctly produces alpha that exceeds the return
of the underlying investments.

The issue is made complex because very few investments display only one behavior. In
reality, the blend of behaviors means that investors need to be vigilant caretakers of their
portfolios.

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Glossary
Average Investor
The average investor refers to the universe of all mutual fund investors whose actions and
financial results are restated to represent a single investor. This approach allows the entire
universe of mutual fund investors to be used as the statistical sample, ensuring ultimate
reliability.

[Average] Investor Behavior

QAIB quantitatively measures sales, redemptions and exchanges (provided by the
Investment Company Institute) and describes these measures as investor behaviors. The
measurement of investor behavior is the net dollar volume of these activities that occur in a
single month during the period being analyzed.

[Average] Investor Return (Performance)

QAIB calculates investor returns as the change in assets, after excluding sales, redemptions,
and exchanges. This method of calculation captures realized and unrealized capital gains,
dividends, interest, trading costs, sales charges, fees, expenses and any other costs. After
calculating investor returns in dollar terms (above) two percentages are calculated:
Total investor return rate for the period
Annualized investor return rate

Total return rate is determined by calculating the investor return dollars as a percentage of
the net of the sales, redemptions and exchanges for the period.

Annualized return rate is calculated as the uniform rate that can be compounded annually
for the period under consideration to produce the investor return dollars.

Dollar Cost Averaging

Dollar cost averaging results are based on the equal monthly investments into a fund where
performance is identical to the appropriate benchmark (either the S&P 500 or the Barclays
Aggregate Bond Index). Investments total $10,000 over 20 years. Dollar values represent
the total amount accumulated after the period under consideration. The percentage is the
uniform annualized return rate required to produce the dollar returns.

Guess Right Ratio

The Guess Right Ratio is the frequency that the average investor makes a short-term gain.
One point is scored each month when the average investor has net inflows and the market
(S&P 500) rises in the next month. A point is also scored when the average investor has net
outflows and the market declines in the next month. The ratio is the number of points
scored as a percentage of the total number of months under consideration.

Holding Period
Holding period (retention rate) reflects the length of time the average investor holds a fund
if the current redemption rate persists. It is the time required to fully redeem the account.
Retention rates are expressed in years and fractions of years.

Hypothetical Average Investor

A $10,000 investment is made in a pattern identical to the average investor behavior for the
period and asset class under consideration. Rates of return are applied each month that are
identical to the investor return for each month.

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The resulting dollar value represents what a $10,000 investment would be worth to the
average investor. The dollar amount of the return is then converted to an annualized rate.

Hypothetical Systematic Investor

A $10,000 investment is evenly distributed across each month for the period under
consideration. The appropriate benchmark (either the S&P 500 or the Barclays Aggregate
Bond Index) is used as an assumed return rate and applied each month.
The resulting dollar value represents what $10,000 would be worth to the systematic
investor. The dollar amount of the return is then converted to an annualized rate.

Inflation Rate
The monthly value of the consumer price index is converted to a monthly rate. The monthly
rates are used to compound a return for the period under consideration. This result is then
annualized to produce the inflation rate for the period.

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Appendices

1. Year-by-Year Investor Returns

2. Investor Return Calculations: An Example
3. Rights of Usage and Sourcing Information

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Year-by-Year Investor Returns
The following table shows the one-year investor return for the 20-year period from 1991 to
2010. These calculations assume that investors start investing on January 1 of each year
and withdraw their investments on December 31. The effect of compounding across years is
therefore lost.

Additionally, because of the year-by-year nature of the calculation, returns cannot be asset
weighted.

Year Equity Fixed Income Asset Allocation

1991 29.40% 11.94% 17.25%
1992 7.28% 8.60% 1.13%
1993 15.93% 7.87% 16.66%
1994 -0.02% -4.99% -5.48%
1995 26.52% 14.37% 25.36%
1996 17.33% 7.71% 11.51%
1997 20.59% 8.14% 16.02%
1998 34.48% 5.92% 32.40%
1999 26.58% -5.68% 5.47%
2000 -9.46% 2.58% -4.27%
2001 -14.81% -0.75% -5.41%
2002 -21.92% 2.72% -10.09%
2003 29.82% 4.18% 17.69%
2004 12.56% 1.37% 7.55%
2005 8.33% -0.49% 2.00%
2006 14.64% 1.96% 10.87%
2007 7.25% 1.00% 3.45%
2008 -41.66% -11.69% -30.53%
2009 32.12% 9.72% 19.11%
2010 13.60% 2.99% 9.34%

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Investor Return Calculation: An Example
Investor return is calculated by measuring the actual gains that investors realize. The
following example is hypothetical:

Step 1: Compute Monthly Net Change

1/31 Assets - 12/31 Assets =
The equity assets at the end of 1/31 are subtracted Change
from the assets at 12/31 to determine the change for
the month. The change is the net of investor actions 5196 4940
[new investments, withdrawals (redemptions), = 256
exchanges in and out], changes in market value, net
of loads, fees, expenses, commissions, etc. (In $ Billions)

Monthly Change 256

Minus New Investments -123 Step 2: Compute Change in Market Value
Plus Withdrawals +105 The change in assets due to investor actions are
Minus Exchanges in -25 deducted from monthly net change, resulting in the
Plus Exchanges out +12 market value change that is net of loads, fees,
Equal Net Change in Market expenses, commissions, etc. The net change in market
Value 225 value is the return earned by the investor for the
(In $ Billions) month, after all fees and expenses are paid. This could
be either a gain or loss.
January 225
February -28
March +106
April +106
May -213
Step 3: Calculate Total for Period
June -5
The calculation is repeated for each month to develop the total
July -20
for the periods for which the investor return is being measured August +119
(1, 3, 5, 10 and 20 years.) September +88
October +195
The example illustrates a one-year period. Note that the average November +154
investor suffered losses in February, May, June and July but December +30
these were more than offset by the gains in the other months. Total for period 757

Opening Assets 4940

Plus New Investments +1288
Minus Withdrawals -1150
Plus Exchanges in +206
Minus Exchanges out -128
Equal Cost Basis 5156 Step 4: Determine Cost Basis
(In $ Billions)
The cost basis is the opening balance for the
period adjusted by the investor actions (new
investments, withdrawals, exchanges in and
out).

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Step 5: Calculate Investor Return Investor Return $ / Cost Basis =
Percentage % Return
Dividing the investor return dollars calculated in
Step 3 by the cost basis in Step 4 gives the total 756 / 5156= 15%
investor return percentage.
(In $ Billions)

Step 6: Find Annualized Rate of Return

Annualized return is then calculated. This is the single rate that can be compounded for
each year to produce the same effect as the varying monthly rates. Since the period in our
example is only one year, the annualized investor return is the same as the total investor
return.

The formula used to calculate annualized return is:

Annualized Return =

[% Return^(1/years)]-1

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Rights of Usage and Sourcing Information
Rights to use portions of the content of this report are granted on the condition the user
makes required regulatory disclosures and sources QAIB and DALBAR as appropriate (see
below). These rights are conveyed to purchasers for their own use and are limited to their
own specific publications. Following are examples of appropriate sourcing and disclosure
statements:

Source: Quantitative Analysis of Investor Behavior, 2011, DALBAR, Inc. www.dalbar.com

Equity benchmark performance and systematic equity investing examples are represented
by the Standard & Poors 500 Composite Index, an unmanaged index of 500 common stocks
generally considered representative of the U.S. stock market. Indexes do not take into
account the fees and expenses associated with investing, and individuals cannot invest
directly in any index. Past performance cannot guarantee future results.

Bond benchmark performance and systematic bond investing examples are represented by
the Barclays Aggregate Bond Index, an unmanaged index of bonds generally considered
representative of the bond market. Indexes do not take into account the fees and expenses
associated with investing, and individuals cannot invest directly in any index. Past
performance cannot guarantee future results.

Average stock investor, average bond investor and average asset allocation investor
performance results are based on a DALBAR study, Quantitative Analysis of Investor
Behavior (QAIB), 2011. DALBAR is an independent, Boston-based financial research firm.
Using monthly fund data supplied by the Investment Company Institute, QAIB calculates
investor returns as the change in assets after excluding sales, redemptions and exchanges.
This method of calculation captures realized and unrealized capital gains, dividends, interest,
trading costs, sales charges, fees, expenses and any other costs. After calculating investor
returns in dollar terms, two percentages are calculated for the period examined: Total
investor return rate and annualized investor return rate. Total return rate is determined by
calculating the investor return dollars as a percentage of the net of the sales, redemptions,
and exchanges for the period.

Systematic investing examples are hypothetical and for illustrative purposes only. Systematic
investing involves continuous investments regardless of security price levels. It cannot
assure a profit or protect against loss in declining markets.

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