Are Investors Their Own Worst Enemy?

When it comes to investing, people are often their own worst enemy.  Emotions, such as fear and greed have a way of driving even the most rational people to make investment decision that result in under performance.  According to a study by DALBAR, Inc., a financial services market research company, the returns most investors experience are significantly less than the actual returns of the mutual funds in which they invest.  In 2014, the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%.  Over the 20 year period ending in 2014, the S&P 500 index returned 9.85%, but the average equity fund investor only earned 4.66%.

Why? DALBAR concludes that investors are at their worst when the market does poorly, selling when they have a big paper loss and then remaining in cash until the markets have recovered.  Therefore, they participate in the market primarily when it is in retreat and miss the market when it is on the rise.  Some of the behavioral mistakes investors make include:

1. Trying to time the market: Few investors have been able to move in and out of the market at the right time consistently enough that they gain any significant advantage over the buy-and-hold crowd. Morningstar estimates that the returns on portfolios that tried to time the market over the last decade underperformed the average return on equity funds by 1.5 %, including several years of negative returns.  To do better, investors would need to have predicted market shifts seven out of ten times, a feat that true timing pros have a hard time matching.
2. Reacting to short-term events: The behavioral instinct of humans to want to do something in response to extreme market events is a survival mechanism that tends to work against us in the investment sphere. Studies have shown that the more often one changes one’s portfolio, the lower the return. When investors shift their focus away from their long-term objectives to short-term performance, the results are almost always negative. This can best be illustrated when investors bail out of a declining equity market with the intention of getting back in when it turns around – a feat very few investors can actually achieve.  Warren Buffet warns “The stock market is a highly efficient mechanism for the transfer of wealth from the impatient to the patient.” Market crashes, financial meltdowns, Middle East wars, and tsunamis are all consequential to our lives in the moment; however, their impact on the markets over a 20- or 30-year period is so minimal as to cause nothing more than a tiny blip on your long-term investment performance.
3. Not having a strategy: Whether investing for retirement or any other objective, the biggest mistake many people make is not having an investment strategy in place to provide an objective framework for their decisions. Without an investment strategy based in sound principles and practices, investors will impatiently succumb to fear or greed, and will act in ways that are counter to their long-term goals.