According to Dalbar, people who managed their own investments over the last twenty years achieved a 2.5% return while the S&P 500 went up 9.2%. Why such a disparity? Simply, it is hard to make sound unbiased decisions about your own money.
Dalbar is a financial market research firm and according to their numbers, the S&P 500 generated a 9.2% annualized return over the last 20 years. During the same time period, gold produced a 5.8%, while bonds yielded a total return of 5.7%.
Based on these numbers, how well do you think the average investor should have performed? Shockingly, the average investor realized only a meager 2.5% return over the past 20 years. Over the same time period, inflation averaged 2.4%. Think about it. This means the average “do-it-yourself” investor barely beat inflation by 0.1% per year! Not exactly the performance one would guess, right?
Why the Underperformance? Emotions!
We humans are emotional creatures. Research shows that the main reasons for the dismal performance are related to emotional and behavioral factors. Turns out, the majority of us are terrible investors when investing our own money due to the way our brain is wired. We just simply aren’t programmed to be rational, disciplined investors. We have a myriad of behavioral biases which stem from emotions that impair our decision-making processes. As a result, people make irrational decisions at the worst possible times, which in turn lead to the lackluster investor performance.
Emotional Biases
If you are going to manage your own investments, you will need to master your emotions and behavior. This is not easy, because it is extremely difficult to emotionally detach ourselves from our money. Investors need to recognize the biases they are most prone to. Below is an overview of the common “money-losing” behavior biases of the average investor:
Overconfidence. Do you believe you have a good grasp of where the market is heading because you stay on top of the financial news? Guess what, you are not the only one. Research suggests that humans are hard-wired to see themselves in the most positive terms, which leads to overconfidence. Investors repeatedly overestimate their ability to predict market events. This leads to higher frequency of trading, which typically results in lower returns.
Chasing performance. The average investor repeatedly performs the cardinal sin of investing, which is “buying high and selling low”. Studies show that individual investors tend to wait to invest until they see strong market returns. By the time their money is invested, they may have missed the majority of the market increase. On the other hand, investors tend to panic after a significant decline and usually sell out near the bottom. Waiting too long to invest and selling on fear will inevitably hurt a portfolio’s return.
Loss Avoidance. The average investor seeks to avoid losses, because it causes pain. What this means is that the pain we experience from losses is more powerful than the pleasure we get from a gain. This phenomenon leads to making irrational investment decisions. By seeking to avoid losses, the average investor tends to hang on to the losers too long. As a side note, many investors don’t realize just how difficult it is to make up that loss. For example, if you experience a 50% decline in your investment, you would need a 100% appreciation just to break even!
Conclusion
As the research shows, most individual investors have a difficult time ignoring their emotions when making investment decisions. Developing and sticking with a long-term investment strategy and avoiding emotional biases should be the goal of those desiring to self-manage. If this is unsuccessful, consideration should be given to seeking professional assistance.
Anthony Bykovsky, CFA, an Associate Portfolio Manager at Bedel Financial Consulting, contributed to this article.