Why Does The Average Investor Underperform The Market?

Dalbar Inc. is a market research firm in the financial services industry.  Their goals are to raise the standards of excellence among financial professionals.  Blackrock is an investment management corporation, and currently the world’s largest asset manager with 5.1 Trillion Dollars under management.

A recent study by BlackRock measures the average investor returns relative to the S&P 500, and other indexes such as Bonds, Gold, and International stocks.  BlackRock came to the conclusion that the average investor not only grossly underperforms the market, but doesn’t even outpace inflation.

*Based on research, from 1996 through 2016, the average investor earned a return of 2.11% versus 8.19% for the S&P 500.  During that same time horizon inflation averaged 2.18%.  The fact that an average investor is receiving approximately 25% of the returns of the S&P 500 is alarming, but what’s even more concerning is that the Real Value (Total Return-Inflation) declined the past 20 years.  Let’s explore some of the reasons for this, and how investors can guard against vast underperformance.

The main reason for underperformance isn’t the fact that investors are choosing the wrong stocks, but are buying high and selling low.  Despite the fact that we know the goal to investing is to buy low and sell high, this proves to be a difficult concept for many to achieve.  Humans are susceptible to many emotional biases.  For this reason, some are poor investors when managing their own money.

Behavioral Finance is a relatively new field that seeks to explain why humans make irrational investment decisions.  A common behavioral bias is myopic loss aversion which is defined as an investor who focuses too much on short term market outcomes at the cost of long term gains.  For example:  Your portfolio is earmarked for retirement in fifteen years and the market declines substantially in a few days.  Instead of understanding markets can be volatile in the short term and sticking with your asset allocation plan, you panic and sell your stocks.  You’ve most likely sacrificed long term gains for less short term pain.  If stocks decline further you will be relieved in the short term for not participating in the decline.  However, history tells us it’s unlikely you’ll buy back below what you sold for.  Therefore, you’ll be buying back at a higher price.

People tend to want to buy stocks when they see the price increasing, and sell when declining.  Perhaps this is because when an asset is increasing and they don’t own it, they feel like they’re missing out.  On the other hand, some investors want to sell an asset when it’s declining.  You may notice when you buy a stock and it declines this causes more pain than an increase causes joy.  People ultimately end up buying high and selling low.  Selling an asset only because the price has declined is not a good reason to sell.

There are certainly valid reasons to sell an investment that has declined.  Perhaps the environment has changed and that investment is unlikely to perform as well as initially thought.

Perhaps an individual’s situation has changed.  For example, the investor bought a small cap stock 15 years ago and now that he’s retiring he shouldn’t have such a large percentage in small cap stocks.  Downsizing the small cap position may be necessary to align the portfolio with the investor’s risk tolerance as he transitions into retirement.

Another reason to sell is tax loss harvesting.  An investment has declined, and selling that investment to realize the loss can offset future gains.  For example, if you own an S&P 500 index and there’s a $10,000 short term loss, you can sell that index and buy a similar index such as the Wilshire 5000.  You’ve realized a $10,000 loss to offset future gains while maintaining a similar risk profile.

There’s a couple actions an investor can take to minimize the desire of buying high and selling low.  The most obvious is diversifying among stocks, bonds, and alternatives.  By diversifying, you are narrowing your range of returns.  The highs may not be as high, but the lows may not be as low.  This means you’re less likely to sell if stocks decline, since other assets may increase to offset the declines of stocks.

If you need capital within the next year, your money probably should not be invested in risky assets such as stocks, but in cash or cash equivalents.  Therefore, it’s unnecessary to view the portfolio’s value every day.  If you’re looking at your stock and bond portfolio daily I would encourage you to consider looking at the value less frequently.  Viewing your accounts daily are more likely to cause panic when the portfolio temporarily declines.  Understand that if looking at the value of your portfolio daily, you will see many days when the portfolio has declined.  However, annual stock returns (measured by S&P 500 index) are positive the vast majority of the time.  **From 1940 (After the depression) through 2016 the S&P 500 has declined only 17 times in a Calendar Year.  Approximately 80% of the time in the past 77 years, the S&P 500 index increased from January 1st through December 31st.

Rather than look at the value daily, perhaps view weekly.  If you look at the value weekly, try viewing monthly, and if viewing monthly look at your portfolio balance quarterly.  Since your portfolio is earmarked for the long term, is there a need to view the balance every day?  (If you are an investor who understands the markets will fluctuate, and don’t think you’ll panic when markets decline, then perhaps it’s ok to look at more frequently than somebody who may have a more emotional response to market volatility).

Understand that Price and Value move in the opposite directions.  As the Price of an asset increases, the future returns become past returns.  The asset is becoming more expensive and less valuable.  Understanding this concept will lead you to question if you should buy something only because it’s increasing, or sell only because it’s declining.

The relationship between Price and Value can serve as a reminder to rebalance the portfolio.  Rebalancing will force you to sell what’s performed well, and buy what hasn’t.  Essentially, you are buying low and selling high.

To minimize the chances of grossly underperforming benchmarks such as the S&P 500 index, it’s critical to be cognizant of emotional biases that many humans are privy to.  Additionally, understand it’s very difficult to make unemotional decisions when managing your own wealth.  A solution may be partnering with a trusted, and knowledgeable financial advisor.  The advisor can serve as a sounding board that can give honest feedback on what’s best for you, with the intention of helping you avoid making poor decisions that will hinder you from reaching your long-term goals.

Sincerely,

Philip B. Snyder, CFA

2017-12-07T15:20:02+00:00

About the Author:

Philip is a graduate of Hofstra University with a Bachelor of Arts in Business Management. He is a Chartered Financial Analyst Charter Holder and a member of the Baltimore CFA Society. He is FINRA Series 7 and 66 licensed.