In a few weeks, calendar year 2018 will come to a close. A few months later, American investors will be receiving their annual report card. And once again, on average, we are expected to see results that could use significant improvement.
Each year, DALBAR Inc., the nation’s leading financial services market research firm, issues their Quantitative Analysis of Investor Behavior Report (QAIB) in which they examine real investor returns in equity, fixed income, and asset allocation funds.
Beginning the 1980s, they take a thirty year look at average returns for various broad-based indexes and then compare those numbers to the performance realized by actual investors. Last year’s report analyzed data from 1987-2017, including the recovery from the crash of 1987, the drop and recovery at the turn of the millennium, and the downturn and recovery after 2008.
While the markets had their ups and downs, DALBAR found that over the three decade period the S&P 500 Index made annual average gains of 11.96%.
But for the same timespan, equity fund investors averaged returns of only 7.26%. That means they realized less than 61% of the gains they could have made simply be getting the broad index return. In most schools that percentage would earn a low D minus.
Why are investors on average doing so poorly in comparison to the broad stock market benchmark?
The QAIB report looked at factors that can hinder performance, including taxes, trading costs, and fees. But they found that far and away the biggest detriment to investors’ returns was their own misguided behavior.
DALBAR states it plainly: “Investment results are more dependent on investor behavior than on fund performance.”
Specifically, they found that the average investor is likely to jump in and out of investments every few years, with timing that cements their losses and hamstrings their gains.
A Psychological Problem
Why are people so prone to act against their own best interests when it comes to investing their hard-earned money? The report identifies nine separate irrational investment behavior biases, ranging from “narrow framing” (not looking at the big picture) to “anchoring” (focusing on the past) to “mental accounting” (justifying losses).
Summarizing the 2017 QAIB report for MarketWatch, analyst Lance Roberts says that the two worst of these biases are the “herding effect” and “loss aversion.”
“These two behaviors tend to function together,” he says. Investors chase performance, buying high and expecting the instrument to go up indefinitely, then as it goes down, selling when the anxiety becomes too much.
In other words, underperformance is caused by the psychological behavior of the investor.
“This is why,” Roberts says, “all great investors have strict investment disciplines that they follow to reduce the harm of human emotions.”
And this seemingly ingrained psychological factor is also why we don’t expect this year’s report card for the average investor to be much better than the previous ones. Recent stock market volatility increases the temptation to undermine long-term return results by over-focusing on short term noise. Unfortunately, many investors who haven’t learned from history will probably be bound to repeat it.
You, however, don’t have to endure the costly mistakes of your peers. We can help you avoid the behaviors that can hamper your long-term investing goals no matter what the market is doing in the short-term.