Investment returns – it’s all in the head

Dalbar published their annual Quantitative Analysis of Investor Behaviour recently. This report compares the performance of the stock market versus what investors actually get. In 2014, the average mutual fund investor underperformed the S&P 500 by 8.19%.

Why do investors consistently underperform the market?

Dalbar found the biggest reason that investor underperform the market is because of human behaviour. They defined nine behaviours that lead to people making irrational decisions about their money.

  1. Loss Aversion – the fear of losing money. Some studies have shown that the fear of losing money is twice as powerful as the joy of making money.
  2. Narrow Framing – making investment decisions without consideration of the context of the whole portfolio.
  3. Anchoring – Using irrelevant information as a reference point. A typical example is people holding on to a bad investment until it has returned to the price the paid for it and they break even. They are anchored to that price when what they should do is sell at a loss and buy something with better value.
  4. Mental Accounting – Using different investment strategies for different amounts of money. Example, holding cash for short term investment and equities for retirement.
  5. Lack of diversification –  Not fully understanding the relationship between investments. Investing in US and European stocks is not diversification, the both go up and down at the same time. Having stocks and bonds is diversification.
  6. Herding – Doing what everyone else is doing. It leads to panic selling and buying in at high prices.
  7. Regret – Letting the regret of a past decision influence your future decisions.
  8. Media Response – The media has a bias to optimism to sell products from advertisers and attract viewers
  9. Optimism – Being overly optimistic leads to dramatic reversions when met with the reality

What can you do about it?

  1. Have a plan – What investment strategy is needed for you to reach your goals? What proportion of bonds and equities will you need to achieve this figure?
  2. Know what to expect – What is the potential upside to your investment strategy? Is it enough for you to reach your goal? What are the potential downsides? Will they keep you up at night? If so, change your goals, reduce your risk or put in more money.
  3. Write it down and sign it – Studies have shown that when people write down a goal and sign it, they are more likely to stick with it than when they just keep it in their head. Write down your investment strategy and sign it.
  4. Use an advisor – Have someone objective and who you can trust to remind you of the strategy you had agreed to and the damage deviating from this might cause. This applies to both taking too much risk in the hope of making greater returns or moving into cash during a downturn.

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