The Main Reasons Why Investors Underperform
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Over the past 20 years, the S&P 500 has produced a 9.2% annualized total return.
Over the same period, gold has returned an annualized 6.6%.
And bonds? The Barclays U.S. Aggregate Bond Index has returned 5.7%.
Based on these figures, what type of return do you think the average investor has achieved over this time period?
The answer will shock you . . .
Quantitative analysis from DALBAR, a financial market research firm, shows that the average investor has realized a measly 2.5% return over the past 20 years.
This means the average Joe has outperformed inflation by just 0.2% per year.
Told you it was shocking, right?
But there’s actually a very simple reason why the average return is so dismal. People tend to be terrible investors because of the way our brains work. We have a plethora of behavioral biases that hinder our decision-making processes.
Do you feel like you have a good grasp of what will happen in the financial markets – and an ability to make money based on this knowledge?
Well, you’re not alone . . .
Research suggests that most investors display overconfidence. That is, they overestimate their ability to predict market events.
Behavioral theorists, Brad Barber and Terrance Odean, conducted a study that illustrated the dangers of overconfidence. They divided clients at a large brokerage firm into groups, based on their frequency of trading. The results showed that the return for the group that traded most frequently was about 6% less than the group that traded the least.
Other biases include the bandwagon effect, which leads to herding behavior. This helps explain why there are so many “glamour” stocks with P/E ratios greater than 100x.
In addition, Daniel Kahneman and Amos Tversky’s work on loss aversion indicates that our pain from loss is more acute than our pleasure from gain.
These behavioral biases largely result from us being emotional creatures.
We tend to make irrational decisions at the worst possible moments.
The average investor becomes euphoric at market peaks and goes all-in. On the flipside, they panic after a significant decline, usually selling at the bottom.
The combination of cognitive biases and emotional decision-making leads to the lackluster investor performance seen in the chart above.
An important step in overcoming these shortcomings is to have a plan.
What Will You Do When the Market Drops Again?
An investment policy statement (IPS) is a written plan that includes details about your goals, risk tolerance and investment strategy. Morningstar even has a downloadable Investment Policy Worksheet (PDF form).
Everyone should draft an IPS. However, the preparation doesn’t stop there.
In your mind, imagine the emotions associated with various potential outcomes. For example, think about how you’d react if each of your stocks or ETFs experienced a significant decline.
Now is a great time to perform this mental exercise, considering that the S&P 500 has gone over two years without a 10% correction.
Are you prepared? What will you do when it occurs? What’s your plan of action if the correction extends beyond 10%? What if the market continues to grind higher, instead?
Planning is what will separate us from average investors, who may barely outperform inflation over the next 20 years.
Alan Gula, CFA