Investors Predictably Underperform

Investors face three primary challenges:  Behavior biases; loss of compounding from large portfolio losses; and the opportunity cost of being too conservative.  This article looks at behavioral biases.   

Boston-based DALBAR, Inc has been studying investor behavior since the late 1970’s. Each year, DALBAR’s annual Quantitative Analysis of Investor Behavior (QUAIB) has measured the gap between leading indicators of investment performance and what investors actually earn from mutual fund investing.  

The study measures the effects of an investor’s decision to buy, sell, and switch in and out of various mutual funds over different time frames. And the results consistently show that the average investor earns less, in many cases much less than the returns reported in the mutual fund’s performance report.

Their research proves that individual investors wait to buy until the market has gone up and then they sell after it drops. Of course, no one would want to admit that they invest like this, by the research shows time and again that investors do the EXACT OPPOSITE of what they need to do to be a successful investor.

In 2018, DALBAR reported that the 20-year annualized S&P return was 7.20% while the 20-year annualized return for the average equity mutual fund investor was only 5.29%, a gap of nearly 2% per annum.

And when you look even closer, it doesn’t matter what the time frame is, individual investors still underperform.  

Another interesting piece of Data gleaned from the DALBAR data has to do with retention rates.  Even though many investors would say that they are investing for the “long term”, the average retention rate for most mutual funds is less than five years – hardly long term.   

Why is this? How could investors do so poorly even during periods of strong economic prosperity?

Human emotion.  

It’s the emotions of fear and greed with a healthy dose of herd behavior (individual investors acting collectively as a whole without central direction) that have long been seen as main drivers of investor behavior and irrational investment decisions.

Investors are constantly in search of the “story” stock or for the latest “hot fund” and are willing to jump in with both feet when it feels right.  

Worse yet, when things go south, investors start to feel awful and they end up liquidating their investments at the worst possible time.

You are your own worst enemy.

It’s nothing personal.  Truth is, I’m no exception.  When it comes to investing putting money at risk we are all our own worst enemy.

Why? Because we’re human.

And as well intended as we may be … we can all behave irrationally.

This has given rise to a new field of study called behavioral finance.  Don’t worry, I’m not going to go off on some tangent here, you just need to know that the effects of human emotion are so powerful, there are entire subsections of economic research devoted to trying to understand it.

In short, behavioral finance attempts to provide an explanation for why people make irrational financial decisions. It tries to understand that when your money is on the line, riding the market’s peaks and valleys, why do we have a natural tendency to do the opposite of what we should be doing.

The human brain is capable of incredible things, but it’s also extremely flawed at times.

Science has shown that we tend to make all sorts of mental mistakes, called “cognitive biases”, that can affect both our thinking and actions. These biases can lead to us extrapolating information from the wrong sources, seeking to confirm existing beliefs, or failing to remember events the way they actually happened!

Recently a study identified 188 cognitive biases, systematic patterns of behavior and irrational thinking that the human brain performs.

To be sure, this is all part of being human – but such cognitive biases can also have a profound effect on our endeavors, investments, and life in general.

But, once you see the proven patterns of our “behavioral tendencies”, you can remove an enormous amount of human emotion by using a systematic and formulaic process.

Systematic investing demands a level of rigor, clarity, and consistency beyond industry standards of asset management. The framework calls for a set of precise mathematical or quantitative methodologies that differ from more commonly used fundamental processes built on narratives and forecasts.

When investors have a structured, rules-based process to invest with, it leaves less room for any of these 188 biases to interfere.   

Just what rules to use and how to adopt a rules-based process will be the topic of a future post.