Investor Biases – Part II
Good Morning Relaxing Retirement Member,
Last week, I revealed the results of the recently published 23rd 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, here is what the recently published DALBAR Report revealed 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%
This 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 asked 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?
As we concluded, 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.
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 average 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 96% of active mutual fund managers can’t beat their respective index over a ten-year period 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?
- 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.
- Staying Home Bias: While the share of the value of the world’s companies headquartered in the United States is only 49%, Americans invest 73% of their wealth in American companies.
This may sound patriotic, but it doesn’t make much sense from an investment perspective. 51% 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 14.1% per year, i.e. at some point during the year, prices fell 14.1% on average.
- Since 1945 (72 years), there have been 14 market crashes averaging 30%. That’s an average of once every five years.
- In spite of all of these, market prices and dividends have risen dramatically outpacing inflation by over 6% per year.
While this is challenging to remember during turbulent times, nobody earns market returns without experiencing market turbulence, corrections, and crashes.
As Peter Lynch said, “more money is lost anticipating market crashes than the crashes themselves.”
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.)