In this Monthly Market Advisor:

  • The average investor often fails to fully capture stock market returns.
  • Investor behavior can be a major contributor to this underperformance.
  • Investor biases are one of the major forces influencing poor returns.
  • Investors should use disciplined strategies to help overcome their biases.

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The Average Investor Fails to Fully Capture Stock Market Returns

Stock market investing is challenging for many investors. Stocks offer the potential for higher returns than many other investments over long periods of time, but markets can be extremely unpredictable over shorter time frames. Risks often appear just around the corner in a world of terrorist attacks and other headline geopolitical risks. The chart below shows the return of an average equity fund investor. Over this 20-year time frame, the average investor’s returns trailed the S&P 500 Index by roughly 2.9 percent annually—meaning the average investor captured approximately 62 percent of the available market return. This performance shortfall could have devastating consequences for investors. For example, those investors close to retirement who have not achieved their long-term return investment goals may need to extend out their target retirement date.

Average Equity Fund Investor Underperformed Benchmark

Source: Dalbar, Inc. 2017, 20 years from 1997-2016; “Quantitative Analysis of Investor Behavior” by Dalbar, Inc. (4/20/2017) and Lipper. Dalbar computed the “average stock fund investor return” by using industry cash flow reports from the Investment Company Institute. The “average stock fund return” figure represents the average return for all funds listed in Lipper’s U.S. Diversified Equity fund classification model. All Dalbar returns were computed using the S&P 500 Index. Returns assume reinvestment of dividends and capital gain distributions. The fact that buy and hold has been a successful strategy in the past does not guarantee that it will continue to be successful in the future. An index is unmanaged and not available for direct investment. The performance shown is not indicative of any particular investment. Past performance is not a guarantee of future results.

Why Does the Average Investor Trail the Stock Market?

The Dalbar study cited above states that “investment results are more dependent on investor behavior than on fund performance.” What specific investor behavior could be causing such significant underperformance? The simple answer is many investors try to time the market—continually moving in and out of stocks. However, based on two decades of data, investors generally fail in this endeavor. According to the study, instead of investing for their long-term objectives, the average investor holds an equity mutual fund for only 3.5 years on average. This short-term holding period means investors do not hold their equity mutual funds for one full stock market cycle, which lasts about five years on average. (Note: The current equity bull market is in its ninth year.)

One of the key findings from the Dalbar study is that most of the underperformance investors experience occurs during times of market turmoil or decline. Investors tend to take action (sell) at precisely the wrong time—when markets are declining. Then, as markets bounce back, investors are underinvested and fail to fully participate in the recovery phase. Investors finally buy back into the stock market after much of the recovery has occurred. 

Last year’s vote in the United Kingdom to exit (or Brexit) from the European Union (EU) provides a good example. After the surprise Brexit vote, global equity markets (including the S&P 500 Index) declined. Some investors sold their equity mutual funds into this decline. In less than one week, however, the S&P 500 Index recovered 80 percent of its losses. Within two weeks of the Brexit vote, stocks were higher than before the vote. The rapid up-and-down movement of stocks and the negative headlines caused reactive selling by investors. This investor overreaction to market volatility hurt their performance, and they likely failed to keep up with the S&P 500 Index returns. 

What’s Behind Investor Biases?

There are a number of investor biases that cause this underperformance. In his book “Thinking, Fast and Slow,” the Nobel Prize-winning author, Daniel Kahneman  describes many of these biases. 

Thinking “fast” refers to the brain’s ability to respond automatically or reflexively to activities. The brain uses short cuts to quickly “solve” the problem. Examples here include:

  • Complete the phrase “bread and _______”
  • Answer 2 + 2 = ____

Thinking “slow” refers to more deliberate thinking that requires concentration and effort. Examples here include:

  • Fill out a tax form
  • Drive on the opposite side of the road in a place such as the U.K. 

Thinking fast shortcuts help individuals make quick decisions in many activities of daily living. Unfortunately, these shortcuts do not always translate well to the investing world. Instead, fast thinking may cause investors to overreact to market movements. The skill of thinking slowly is often one of the keys to successful investing. 

Loss Aversion: A Key Bias Working Against Successful Investing

When the stock market declines, investors’ fears tend to get the better of them and they often sell. Behavioral economists call this tendency “loss aversion.” Logic does not prevail. Thinking “fast” shortcuts (avoiding short-term losses) may overcome the more logical and disciplined thinking “slow” part of the brain (staying invested with the goal of achieving long-term gains). As discussed in the Dalbar Study, investors often sell stocks at the wrong time and then buy again only when their fear has subsided. Unfortunately, by that time, markets have usually recovered. 

Why do investors overreact? Studies show investor emotions around losses have a much stronger effect, or stimulus, than gains. Many studies show that a loss is two times more painful for investors than missing out on a gain. The emotion of seeing a portfolio decline by thousands of dollars is much more powerful than a gain of thousands of dollars. Plus, gains may take years while market declines are often quite rapid. (There is an old stock market adage that markets go up like an escalator and down like an elevator.) The evolution of the brain to flee from trouble has served humans well in many situations, but not necessarily when it comes to investing in stocks. 

Employing Behavioral Coaching to Help Overcome Investor Bias

Some investors are unable to overcome their fears and biases on their own. They may need an investment professional to help them. When markets are declining, investment professionals can dispassionately coach and urge clients to stick to their investment plan. The Vanguard Group has studied the value investment professionals provide to investors. Vanguard estimates that investment professionals who successfully coach investors to avoid making emotional decisions can add 1.50 percent annually to the return of their portfolios. This added value is consistent with the Dalbar Study results, since advisors can help overcome investor biases. 

Our “Rules” for Playing a Winner’s Game

We believe playing a “winner’s game” does not require an investor to ignore biases such as loss aversion. Instead, our approach accepts investor biases. In our opinion, an investor who is able to embrace a disciplined process to help manage and minimize investor fears can seek to avoid mistakes. 

The first step in the process is for investors to capture all their unique goals, aspirations, and dreams. This step embraces emotion. The next step is to translate these goals and aspirations quantitatively into an investment plan. This quantitative translation determines an investor’s long-term desired rate of return and their ability to tolerate the risk of portfolio fluctuation.

Once an investor determines their desired rate of return, an appropriate asset allocation mix can be determined. Rather than looking at individual investments, a mix of investments can help smooth returns by including not just stocks, bonds, and cash alternatives but other asset classes as well. Each slice of the pie has unique characteristics that help layer in diversifying portfolio characteristics. Most investors do not need to take the full risk of all-equity portfolios. Owning a more diversified portfolio should help overcome investor fears such as loss aversion since fluctuations in a portfolio’s value should be diminished. This can potentially help investors better handle stock market declines and allow them to stay committed to their long-term strategy.

Conclusion

Investor biases can negatively influence their behaviors and cause them to underperform the markets. Additionally, investors who overreact to stock market moves may fail to achieve their unique investment objectives, such as affording a comfortable retirement. Investors can employ advisors (or “financial coaches”) who can help take the emotion out of the investment decision-making process. Advisors who employ disciplined strategies such as financial planning and asset allocation can help increase the odds of a successful outcome and reduce investor fears of losses. Investors can learn how to accept periodic stock market declines, avoid investment mistakes, and overcome their biases.