Investor Biases – Part I
Good Morning Relaxing Retirement Member,
Last week, I shared the Wall Street Journal article with you highlighting the fact that investors had stopped pulling money out of equity funds at the end of August, ending a record breaking ten-week span where they withdrew $30 billion!
As we discussed, one of the biggest reasons why most investors grossly underperform broad market returns is they fall prey to one of several investor biases. And, the most recent one is known as recency bias, i.e. mistaking recent events for ongoing “trends.”
There are several other deadly investor biases to avoid like the plague that I want to share with you so you can constantly be on alert.
Before I do that, I want to quickly explore the results of the recently published 23rd Annual DALBAR Quantitative Analysis of Investor Behavior (QAIB).
As a refresher, DALBAR is the financial community’s leading independent expert for evaluating, auditing and rating business practices, customer performance, product quality and service.
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.
Here’s what the recently published DALBAR Report reveals about the 30-year period from 1986 through December 31, 2016 (the average length of retirement based on joint life expectancy tables):
- The Average annual return of the broad market S&P 500 Stock Index from 1986 – 2016 was 10.16% (including dividends reinvested)
- However, over the same 30 year period, the average annual return of the “average” equity mutual fund investor (not investment, but an investor, i.e. a person) was 3.98%
Please read those numbers again.
What these numbers tell us is that, while the standard barometer for broad stock market performance, otherwise known as the S&P 500 Index, delivered an annual return over those 30 years of 10.16%, the average investor who invested in stock mutual funds (a person, not an investment) only achieved 3.98%!
That means that the average investor’s return was 60.83% less than the market barometer of “average” returns (not above average) each and every year!
The question we have to ask after reading these horrifying statistics is why?
Why do the investment results of the average investor so drastically trail the most basic index of broad stock market returns?
It certainly wasn’t “the market” because the market delivered a perfectly acceptable return, and the average investor earned 60.83% less than market returns.
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.
We’re going to dive into these root causes over the coming weeks so we can do everything in our power to help you avoid these horrific results and close this gap!
When we closely examine investor behavior, as I have for decades, there are several investor biases that they bring to the investing table each day which drive their investing behavior. And, this is what leads to the horrific results reported by DALBAR.
- Recency Bias: One of those, which we touched on above, is Recency Bias, i.e. mistaking recent events for ongoing “trends,” and thus repositioning your investments accordingly in order to take advantage of their “hunch.”
- Endowment Effect Bias: Another one is what is known as the Endowment Effect Bias which occurs when investors place greater value on something they already own, i.e. they are very subjective.
- They begin the process by justifying what they have done up until now, and focusing on what they already own as the starting point. This information is of value when trying to understand the mindset behind prior decisions. But, it is of no value when objectively evaluating and designing an effective investment mix to achieve long term future goals.
- A great question to ask if you find yourself engaging in this behavior is, “if you didn’t already own what you currently own, and all of your money was in cash, would you go out and buy the exact investments in the exact same quantities as you currently hold them?”
- When asked that way, most instinctively respond “no”.
- If that is true, then the follow-up question is, “why do you continue to own what you own?”
- I know these are tough questions because they challenge our current way of thinking. However, they’re incredibly important to your long-term investment results, and thus your level of financial freedom.
- Confirmation Bias: Another destructive investor bias, closely related to this, is known as Confirmation Bias which occurs when you seek information that confirms your own preconceptions and beliefs.
- What this leads to is avoiding, undervaluing, and even disregarding anything that conflicts with your preconceived beliefs. Ultimately, it closes your mind to what could very well be the truth, and thus a valuable solution for you.
- We’re all guilty of this to some degree in all facets of life. We all like to watch the news stations that slant in the direction which we identify with.
- The danger when investing is that this bias shuts off your ability to objectively evaluate your past decisions, and thus your results. I see this all the time when folks spend wasted energy and time trying to justify and defend their past choices and decisions.
Let’s continue next week by revealing more investor biases, and how you can resist the temptation to follow the crowd and engage in these lines of thinking.
Committed To Your Relaxing Retirement,
The Retirement Coach
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I appreciate the trust you place in me. Thank you! (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.)