By: Richard Hitchock, CFP®
In the financial investing world, it is a well known observation that investors rarely match the performance of the market averages, year in and year out. What is little known is why. When it comes to seeing just how well an individual investor actually does—when looking at the effects of investor decisions to buy, sell and switch into and out of various investments over both short and long-term timeframes, it is startling to see that investor behavior is a culprit in below average performance as well as the actual returns of the market averages.
Very few people, even professionals, are aware of this phenomenon. But, in fact, investor behavior has a huge impact on ultimate performance! Performance figures I’ve observed consistently show that the average investor earns less – in many cases much less – than market index performance reports would suggest. So, how does investor behavior negatively affect performance? Typically by investors buying what has already been bid up and selling what’s cheap. Buying high—selling low.
At the heart of this conundrum is consistency–the ability, first, to have an investment plan and, second, to stick with it. This is hard for everyone! As Warren Buffett commented, “Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, ‘I can calculate the movement of the stars, but not the madness of men.’ If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.”
It is an accepted belief that retail investors, swayed by a barrage of financial news and information, and impulses within their own brains, tend to systematically buy at market peaks and sell at market lows, resulting in returns that are far lower than what could have been achieved by simply sticking to a game-plan. Think of it like this. After a particularly pessimistic time in the market, many investors go to cash. They stay in cash until the market rallies for a bit and then, not being able to stand being in cash, jump into the market. Obviously they buy in at a market level higher than where the market has been. The same type behavior happens when the market starts going down. They hang in the market until they can stand it no longer and sell. It is a great way to guarantee less than stellar results and, unfortunately, a too reliable pattern of behavior.
It comes down to the tendency to chase performance. Chasing performance usually reduces returns. The pattern of buying high and selling low — though, of course, intending to do otherwise — leads to a predictable outcome.
• The S & P 500 index annually from 1991 through 2011averaged 7.8%.
• However, the average stock investor only made 2.1%.*
• Why? Because investors lack knowledge and self-control.
What comes out of this observation should benefit us. Investors need to have a financial plan. A plan with long enough time horizons. One that would probably benefit from a bit less action. A long term financial plan which recognizes that attempts to jump in and out of the market at just the right time are surely well-intentioned but often misguided.
John Bogle, not surprisingly, says it very well: “The way to wealth, it turns out, is to avoid the high-cost, high-turnover, opportunistic marketing modalities that characterize today’s financial service system and rely on the magic of compounding returns. While the interests of the business are served by the aphorism ‘Don’t just stand there. Do something!’ the interests of investors are served by an approach that is its diametrical opposite: ‘Don’t do something. Just stand there!'”
As an avid boater, I often have tried to teach young people (now my grandchildren) how to drive a boat. One of the first lessons is in steering. In the short term, boats veer left to right almost uncontrollably. That’s when I suggest they pick a spot on the distant shore and aim for it. It makes the job so much easier.
In boating, as well as in investing—keep your eye on the horizon!
Investing involves risk including loss of principal.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and my not be invested into directly.
*”Average Investor 20 Year Return Astoundingly Awful” Michael Maye, TheStreet, July 18, 2012 http://www.thestreet.com/story/11621555/1/average-investor-20-year-return-astoundingly-awful.html