Investor Biases You Must Avoid

Good Morning Relaxing Retirement Subscriber,

Last week, I revealed the results of the 25th Annual DALBAR Quantitative Analysis of Investor Behavior (QAIB).

Since 1994, DALBAR’s QAIB has measured the effects of investor decisions to buy, sell, and switch into and out of mutual funds over short and long-term timeframes.  These effects are measured from the perspective of the investor and do not represent performance of the investments themselves.

As a refresher, in addition to reporting that the average investor in equity mutual funds grossly underperformed the market index again in 2018, and each year over the last 30 years, here are a few other disturbing results they reported about investors in 2018:

  • The Average Equity Fund Investor (stocks) withdrew funds every month in which the S&P 500 Index had a material gain,
  • The only month the Average Equity Fund Investor made a significant contribution was a month where the S&P 500 Index lost approximately 2.5%,
  • The Average Equity Fund Investor’s performance trailed the S&P 500 Index in August when market prices soared, and in October when prices fell sharply, i.e. when market prices rose and when they fell,
  • The Average Fixed Income Fund Investor (bonds) lost 2.84% while the Bloomberg/Barclays Aggregate Bond Index gained 0.01%.

The question we always have to ask after reading these disturbing results is why?

Why do the investment results of the average investor so drastically trail the most basic index of broad stock and bond market returns year after year?

The only two logical possibilities are:

  • the fees they paid, which ate into their returns, and
  • “how” they invested, i.e. when they bought, when they sold, what they chased, what they were scared out of, etc., i.e. their investing behavior.

Investor Biases

Last week, we dove into some of the root causes by examining some of the debilitating biases most investors bring to the table.  Before examining the second reason investor returns are so low compared to market returns (i.e. the fees they pay), let’s examine a few more investor biases so you can close this gap!

  • Overconfidence Bias: Overconfidence Bias comes from an underlying belief that you or anybody can consistently predict the future, and benefit from it.

    The question you always have to ask yourself is, “Do I really have an advantage to be a market beating investor?

    The only rational and educated answer to this question is no.  If only 17% of active mutual fund managers have beaten their respective index in a given year with the wealth of information and talent around them, what is the probability that any of us can have a long-term advantage over them?

    And, the 17% is not the same list each year, i.e. the managers who beat their respective index in 2017 is a completely different list than those who did so in 2018!

  • Greed Bias: Another debilitating bias is Greed.  This comes from the desire to hit “home runs” with every dollar you invest.  In essence, this is gambling.

    Gambling occurs when you don’t use high levels of probability to obtain the outcome you want and need.  I see this with some of the folks I’m introduced to whose investments are not linked to stated long-term goals.

    Or, their investments are not linked to reality, i.e. seeking something that doesn’t exist like market returns without market volatility.

    In essence, they’re looking for something that any rational person knows does not exist.

  • Staying Home Bias: While the share of the value of the world’s companies headquartered in the United States is only 52%, Americans invest 76% of their wealth in American companies.

    This may sound patriotic, but it doesn’t make much sense from an investment perspective.  48% of the world’s capitalization lies outside the U.S. in thousands of profitable companies.Staying Home Bias occurs when you place a higher value on a company headquartered in the U.S. simply because it’s located here.

  • Negativity and Loss Aversion Bias: I saved the strongest one for last. Loss Aversion Bias stems from the ingrained “fight or flight” defense mechanism in our brains.

    While that served cavemen well, and saved lives, it is incredibly destructive for long term investor success.The key to overcome this is education and consistent reinforcement in good and bad market climates, i.e. a rational understanding and realization that market corrections and crashes are normal and temporary, and simply part of your investment experience.

    • Since 1980, the S&P 500 Index has experienced a peak-to-trough intra-year market correction of 14% per year, i.e. at some point during the year, prices fell 14% on average.
    • Since 1945 (74 years), there have been 92 stock market pullbacks of 5% or more.
    • 89 of the 92 pullbacks recovered in 14 months or less, and 80 of those 92 recovered in 4 months or less.”In spite of all of these, market prices and dividends have risen dramatically outpacing inflation by 7.3% per year.

While this is challenging to remember during turbulent times, nobody earns market returns without experiencing market turbulence, corrections, and crashes.

As legendary investor Peter Lynch said, “more money is lost anticipating market crashes than the crashes themselves.”

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)