Investors as a group have no idea what they are doing. This has been made clear by a recent DALBAR study spanning 30 years all the way back to 1984.1 This period covers a number of bull and bear markets, giving investors a chance to learn from their mistakes. However, it is clear that they are not learning the lessons of proper investing.
The S&P 500 is one of the most widely followed indices and is considered a benchmark for the US stock market. I would consider it a suitable benchmark for this study. These numbers compiled by DALBAR show that the return of the S&P 500 over the 30 year period ending December 2013 is 11.11%. They also show that individual investors only measured 3.69% over that same period of time. This is a remarkable 7.42% difference annually. To put this in perspective, if you invested $100,000 in 1984 in the S&P 500 and earned 11.11%, today (30 years later) you would have $2,358,275. If you started with $100,000 and invested it over the same time period at 3.69%, you would have $296,556. That is a difference of $2,061,719. It should be clear from these numbers that individual investors have a problem.
Why do so many investors perform so poorly?
What is not clear from this study is why investors have a problem. Some people suggest that it is because investors are not learning, despite all the education currently available to them. While this might be true, I think the problems go deeper than that. Fidelity Investments conducted a study on their Magellan fund from 1977-1990, during Peter Lynch’s tenure.2 His average annual return during this period was 29%. This is a remarkable return over the 13 year period. He was easily one of the best performing fund managers for his asset class. It should be noted that this was not a secret. Fidelity’s Magellan fund became one of the largest mutual funds due to its success under Peter Lynch, so it is clear that investors were aware of its performance. Whether the investors in the fund were chasing performance or investing due to his expertise is unclear. What is clear is that investors learned that Peter Lynch was investing in a method that worked.
Given all that, you would expect that the investors in his fund made substantial returns over that period. However, what Fidelity Investments found in their study was shocking. The average investor in the fund actually lost money. You read that correctly… The average investor lost money in the Fidelity Magellan fund under Peter Lynch’s tenure during a period of time when the fund returned around 29% annually. So if investors can learn enough to find good investments, why do they consistently perform poorly with their investments?
Individuals make decisions every day with their emotions assisting their judgment. It is part of who we are as human beings. Unfortunately making emotional decisions can be a detriment in the investing world. Investors who let their emotions guide them have a much harder time investing than people who have found ways to master their emotional decision making. Some investors try to master their emotional involvement by using a rules-based system, others use computers to make the decisions for them, and still others invest in indexes through ETFs or mutual funds. There are many ways to remove the emotional component from investing, but most investors don’t realize that their emotions are the problem. You can read my post about fear and greed investing or investing is not gambling to learn more.
Investors who chase performance are highly likely to lose money over the long term. This is not because investing in top performers is a bad strategy. It is because in many cases these investors are not doing any research. All they are doing is looking at a list of mutual funds in their retirement plan and choosing the one or few that are performing the best and putting their money there. Given the highly complex nature of investing, it should be obvious why this does not work. Investors should always know where this money is being invested and why they are investing in that asset.
Many people think they can make money by winning the lottery. If it was easy, then everyone would be a millionaire. Playing the lottery is a tax on people who are bad at math. It is appealing that a little money can turn into a lot of money. However, the odds are highly stacked against you. You can read my post about investing is not gambling.
Part of the casino mentality is based on “having fun” with their investments. Investing should not be fun, it should be treated as work. If you are “having fun” with your investing, then you are doing something wrong. Learning about investing can be fun, but the investing itself should be done in an emotionless fashion if someone wants to be successful at it.
The “me too” lemming investment strategy:
This is a common strategy of people who don’t know what they are doing with their investments. For example, let’s say you have a 401k plan at your company and you don’t know how you should allocate it. You might decide to ask one of your coworkers what he or she is investing in. If you don’t know anything, then how could they possibly know less than you. This happens more than it should. Although it is possible their coworker is a savvy investor, the odds are against it. It is more likely that the co-worker you asked, found his or her allocation from another co-worker.
Another example of this is friends or acquaintances comparing their returns to each other. While one person might have significant returns compared to the other, the person with lesser returns might decide to invest the same way as his friend. This rarely works out. While an investment strategy might work for one person, it may not make sense for someone else. This is also a poor form of investing.
News Based Influence:
According to Jason Zweig, in the 1980s Paul Andreassen, a psychologist, created a number of experiments which showed, “paying close attention to financial news can lead investors to trade too much and to earn lower returns than those who tune out the news.” I concur that this is not only a real problem, but it is getting worse since everyone has access to the news instantaneously with 24-hour news stations. If you are a day-trader, this might be relevant to your daily activities. However, most investors are long-term focused. If your investing timeframe is long term based, you should largely ignore the daily news.
A number of successful investors such as Warren Buffett actually prefer to locate their offices far away from the bustle of Wall Street. If you watch the news, you probably know how sensationalistic it has become. Furthermore, the news is what already happened. If it has happened already, then it will not benefit your investments because the market would have already priced in the news to the stock price. If you want to be a better investor, stick to the facts.
Lastly, the news is frequently wrong. Whether it is because the news stations tried to get the story out quicker than their rivals, or that the reporter is influencing the story with their personal opinions rather than the facts, it happens all the time. Take the Brexit vote in the UK in June 2016. No one knows what will happen if they leave the EU, but yet everyone has an opinion. Obviously, some opinions will be proven incorrect. If you want to be a better investor, stick to the facts.
Fear and Greed Investing:
Fear and Greed
This is one of the biggest reasons for individual investor underperformance. The study done by Fidelity Investments should highlight this. Investors in one of the most successful mutual funds lost money during a period of time where the fund made 29% annually. According to Fidelity, investors would pull their money out of the fund during periods of poor performance, and send it in during good periods. While fear might have saved us from getting eaten by a tiger in prehistoric times, it is detrimental to our investing performance. Read more about this in my Fear and Greed investing post.
The odds are against you.
A 25-year study done by Longboard Asset Management which looked at 3000 stocks (Russell 3000) from 1983 to 2007 showed that the odds are against you for randomly picking winning stocks. The study showed that:
18.5% lost at least 75% of their value
39% of the stocks lost money during the period
64% of the stocks underperformed the Russell 3000
Only 25% of the stocks were responsible for all the market’s gains
This shows that if an investor knew nothing at all and picked stocks at random, they would most likely underperform the benchmark. This is not surprising considering other the studies showed similar results. If the odds are stacked against the individual investor, what should they do?
If the odds are against me investing successfully, what should I do?
It should be clear that individual investors are, on average, not good at investing. This is compounded by the low odds of randomly picking successful stocks. Here are some ways investors can improve their returns.
Work with a professional – Using an expert Mutual Fund consultant is one of the easiest methods of improving investor performance. This choice can remove the emotional attachment you have from your investments. Professional MF consultants have the time and experience to help institute an investment plan and stick to a specific strategy. Most importantly, the MF advisor can help talk you off the ledge during a poor performing period of the market, when the average investor would be selling his investments rather than investing additional funds.
The emotional component of investing is what makes it such a challenging endeavor
Having an expert to help you with your investing is important if you want to improve your performance. Even successful investors have sounding-boards and devil’s advocates to help improve on an investment strategy or thesis.