Money doesn’t make decisions. People do. This is a refrain commonly heard in the financial community when referring to investor behavior. Whether it’s budgeting, saving, or overspending, emotions are drivers of our behavior. But, what most DIY investors don’t generally understand is that emotional investment decisions cause them to lose out on significant investment returns more often than not.
According to Dalbar, Inc., a Massachusetts-based research firm that has been studying the behavior of mutual fund investors and market returns for 25 years, the average equity fund investor earns far less than the index average. For the twenty years ending 12/31/2015, the S&P 500 Index averaged 9.85% a year while the equity fund investor earned a market return of only 5.19%. This means that the average investor over this time period earned just 53% of what the market provided over this period.
In DALBAR’s study conducted in 2018, a number of alarming facts were uncovered.
Compared with the S&P 500, through December 31, 2018, stock mutual fund investors underperformed by 5.88%, annualized, over 30 years, 3.46 percentage points, annualized, over 10 years, and 4.35 percentage points, annualized, over five years.[i] Over the course of thirty-plus years, the average investor has continued to underperform over and over again.
So how can we account for this disparity? And what can we do about it?
Simply put, there are two culprits: fear and a lack of proper guidance. Hype, media headlines, and news of market movement trigger investor emotions and lead to painfully poor decision-making. Essentially, investors panic and triumph at the wrong moments, causing them to prematurely buy and sell their investments. This can largely be explained by the sell-remorse-restore cycle: (1) an investor reacts to an external trigger by selling their investments at a low, (2) they regret making that decision when the market rebounds, and they (3) buy after the rebound when the equity costs more than they sold it for. Hence, a loss of return on both ends.
Or, the reverse occurs and they suffer from overconfidence. Investors believe they can outsmart and outperform the market. A quick win here or there or an overreliance on inaccurate data causes them to believe they can predict what the market will do in the future. Carl Richards does a phenomenal job of explaining the disparity between investor behavior and market returns in his popular book, The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money (2012).
What is the remedy?
Because humans naturally tend to overreact, especially when it comes to money, it helps to have a safety net in place. That is, it’s best to seek the help of a financial professional who can act as an intermediary between you and your emotions. Your advisor will help to assuage your fears when triggers arise, explain to you what is happening in the market, and keep you on track to reach your long-term financial goals. Investors with financial advisors in their corner have a safeguard against their own fear-driven, knee-jerk reactions that can help them maximize their potential return and save themselves from incurring unnecessary loss.
At Meenes Wealth Partners, we specialize in helping clients, both working and retired, work through these natural cycles of emotion when market movement or media hype cause them concern. We also help them to construct wealth-building financial plans that account for the natural movements in the market cycle. If you are a DIY investor in need of financial guidance, or if you are in need of a second opinion on your current plan, schedule a complimentary initial conversation with us anytime. We are here to help you prepare to live life on your own terms.