Investor Behavior: Are You Your Own Worst Enemy?
Your poor investment returns may be entirely your fault! I say that tongue in cheek but Dalbar’s Quantitaive Analysis of Investor Behavior study shows how poorly investors perform relative to benchmarks and the reasons for that underperformance.
DALBAR publishes a study every year. Here are some key takeaways from the 2017 study:
- In 2016, the average equity mutual fund investor underperformed the S&P 500 by a margin of -4.70%. While the broader market made gains of 11.96%, the average equity investor earned only 7.26%.
- In 2016, the average fixed income mutual fund investor underperformed the Bloomberg Barclays Aggregate Bond Index by a margin of -1.42%. The broader bond market realized a return of 2.65% while the average fixed income fund investor earned 1.23%.
- Equity fund retention rates decreased materially in 2016 from 4.10 years to 3.80 years. (This is directly related to psychology and behavior.)
- In 2016, the 20-year annualized S&P return was 7.68% while the 20-year annualized return for the Average Equity Fund Investor was only 4.79%, a gap of -2.89% annualized.
- 2016 was a great study in investor behavior as fear generally won out as evidenced by several months of steep outflows.
Analysis of the underperformance DALBAR data shows concludes that investor behavior is the number one cause of this. Fees are the second leading cause. It’s more than just buying and selling at the wrong time, it’s about breaking down the emotional triggers and traps that plague the investor psyche. This is why it’s important to understand the thoughts and actions that drive poor decision making.
There are nine distinct behaviors that can wreak havoc on investor’s portfolios:
1. Loss Aversion. Loss is felt much deeper than the gratification that comes with gaining. Many bad investor behaviors arise from this, including holding on too long to avoid realizing loss, expecting high returns with low risk and stock picking only those stocks they believe will produce large returns.
2. Narrow Framing. This is when decisions are made without considering all of the implications. Market bubbles are great examples of this. Most of those investments are made based on the hype and initial skyrocketing growth. What often isn’t factored in to those decisions are the economic implications down the road.
3. Mental Accounting. Investments may be mentally segregated, with different criteria and due diligence applied to them. You end up taking undue risk in one area while avoiding rational risk in another. Examples include how people spend tax returns, bonuses, etc.
4. Diversification. While important, investors often tell themselves they are seeking to reduce risk, when they are actually using different sources that may be just as risky. Diversification should again be evaluated as a whole, examining the risks of the different investments. These make up the overall risk of the portfolio. You may not be as “diversified” as you think.
5. Herding. We like to copy the behavior of others even in the face of unfavorable outcomes. This is a representation of confirmation bias to a certain extent. There’s comfort in following the crowd, but it often leads to dire consequences.
6. Regret Aversion. We tend to treat errors of commission more seriously than errors of omission. For example, this causes investors to sell winners prematurely in order to lock in profits before they turn into a loss. It can also cause them to hold losing positions too long, in the hope they may turn profitable.
7. Media Response. It’s easy to react to news from television personalities and financial “gurus” without reasonable examination. Confirmation bias plays a big role here too. If the information investors are listening to and gathering confirms their own beliefs, actions and/or opinions, they fail to gauge how that decision may negatively impact them. They fail to look to other sources of information that challenge their own way of thinking or offer other perspectives.
8. Overconfidence. A natural human thought is that good things happen to me, bad things happen to others. For investors, this causes them to think that they have the skills and knowledge to consistently beat the market. And they’ll succeed, because blow ups don’t happen to them. However, they quickly learn otherwise.
9. Anchoring. We determine how to behave based on previous experiences, and relevant facts. Investors tend to anchor their thoughts to a reference point – like that time they took a risky leap and lucked out with a big reward – even if that reference point has no relevance to the decision at hand.
The long term consequences of poor decision making
Dalbar notes that, since 1994, they have seen that investors are impatient and move into and out of investments too frequently, typically 36 to 56 months depending on the type of fund. These flows tend to happen at the worst possible time. This behavior has been observed every year since 1994. The results are an equity performance gap of 4.7%. In terms of dollars, on a $100,000 account invested for 20 years the difference is shortfall of $185,471*.
*($100,000 invested at market return of 7.69% vs 4.79% over 20 years = $440,874 vs $255,403 respectively.)
These behaviors can be harnessed. They can even be eliminated. Using a rules-based system is one way to do it. Our Factor VI portfolios were created on this very premise and are designed to keep you invested, create a smoother investment experience and remove emotion/bias from the decision-making process.
Ready to learn how to reach your full financial potential by adjusting your behaviors? We’ll teach you how. Get in touch with us today and let’s work together!