With investing, expectations and reality aren’t always the same. You may choose an investment based on its past performance, only to be disappointed by future results. Dalbar’s 2017 Quantitative Analysis of Investor Behavior Study suggests that despite their best intentions, investors routinely miss the mark.
In 2016, for example, the performance of the average stock mutual fund investor lagged the Standard & Poor’s 500 index by a margin of 4.7 percent. Investors earned a 7.26 percent return on average, while the broader market gained 11.96 percent. Although the margins for 20-year annualized returns were narrower, the average investor still lagged the S&P 500 by 2.89 percent.
[See: 10 Ways for Investors to Buy the Market.]
Overall, investors correctly guessed which way the market would move 42 percent of the time in 2016. That’s a steep decline from 2015, when investors guessed right 75 percent of the time. But in both years, the average stock fund investor still couldn’t keep pace with the market.
Fixed-income investors were only a little better. In 2015, the average bond fund investor underperformed the Barclays Aggregate Bond Index by 3.66 percent. The margin closed slightly in 2016, to 1.42 percent, but the typical bond fund investor’s average return was a mere 1.23 percent, compared to 2.65 percent for the bond market as a whole.
Dalbar identifies several reasons why investors don’t meet — or beat — the market. Overwhelmingly, the study points to psychological factors as the main driver of this underperformance. Knowing which behaviors have the potential to be most damaging and how to counteract them could mean the difference between lagging the market and actually beating it — or at least matching it.
Allowing bias to cloud your judgment. Behavioral biases, or the tendency to lean one way or another because of your feelings or perceptions, can influence investment decisions significantly.
Investing biases can be cognitive or emotional. The former refers to how you develop thought patterns regarding your investments. The latter involves how your emotions affect those thought patterns. Both can inhibit investment returns, says Zack Shepard, vice president at Matson Money in Cincinnati.
“Behavior is the top detriment to portfolio performance, and all behavioral biases play a part, ” Shepard says. “Because of market volatility, investors inherently tend to do the opposite of what they should,” leading them to buy high and sell low.
Certain biases create more problems than others. Loss aversion, which is simply the desire to avoid losses, can lead you to sell investments at inopportune times. “People are scared of losing their money,” says Robert Baltzell, president of Los Angeles-based RLB Financial. When fear takes over, you may offload investments without considering the timing or your long-term plan.
Alternatively, Baltzell says fear can result in people going broke because they’re afraid to gamble on riskier investments that may yield higher returns. “The hardest thing for these investors is getting over their fear of losing money.”
Understanding market cycles can help investors to counter their loss aversion tendencies, along with other biases that may be creating unrealistic expectations. “It’s one thing to know that the market moves in cycles and another to withstand the roller coaster when it dips,” says Miranda Carr, president of Finworx in Knoxville, Tennessee. “Many investors hold onto emotional biases that are counterproductive, and loss aversion occurs because investors feel the pain of a loss about twice as strongly as the pleasure from an equally sized gain.”
Loss aversion can trigger other negative biases, like regret aversion and herding behavior. Regret aversion can paralyze investors into not acting out of fear of repeating a past mistake. Herding occurs when investors follow the crowd, regardless of how it may affect their investments. Keeping the market’s movements in perspective can help you suppress those tendencies and promote more stability in your returns over time.
[See: 10 Skills the Best Investors Have.]
Giving way to impatience. Experts often recommend adopting a buy-and-hold mindset, but the Dalbar study suggests that investors struggle to follow that advice. Often, investors are too impatient to stay the course and instead move in and out of investments too quickly. Shepard says one of the biggest mistakes is basing long-term investing decisions on a short-term reaction that an investor has to something happening in the news or the markets.
When investors have a knee-jerk reaction to something like a presidential election, the hit to their portfolio can be disastrous. “The results, on average, are abysmal,” and that’s borne out by the numbers. “Over the last 30 years, the average investor, according to Dalbar, has doubled their money roughly just one time versus four times by owning a globally diversified portfolio and rebalancing,” Shepard says.
Investors are better off considering all the historical data for an investment before making a portfolio decision while tuning out short-term market slides.
Believing that you’re better than you really are. The odds of underperforming may increase when impatience is combined with overconfidence. By having too much faith in their abilities, overconfident investors may be more tempted to try to time the market, says Paula Wieck, portfolio manager at CLS Investments in Omaha, Nebraska.
Wieck says timing the market in the short term is a coin toss because even experts can get it wrong. “The stock market has had a historical probability to generate positive returns over 70 percent of the time,” she says. “Even if investors time sales out of the market correctly, it’s rare that they’ll time their entry back in correctly as well.”
Bill Van Sant, senior vice president and managing director at Univest Wealth Management in Souderton, Pennsylvania, says investors often try to time the market because they think they have the inside track on an investment. In their haste, they trade without performing due diligence. This can play into recency bias, or evaluating a portfolio’s performance based on recent results.
“If an investor has a few recent wins and made some money, they can get caught up in thinking that they’re better than the market,” he says. But when they fall into the cycle of trying to time the market, they only end up hurting themselves.
[See: 8 Times When You Should Sell a Stock.]
The solution, says Baltzell, is a “comprehensive, well-tested plan.” This plan should be grounded in historical data and provide a road map for accomplishing your goals, even when the market is bumpy. This can minimize the stress that may prompt you to bail out of the market or make decisions that could hurt your investing performance. “If an investor can see their plan has the highest probability of helping them achieve their goals, they’ll stay committed and stay on track.”
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