By John Drachman
Year in, year out mutual fund investors consistently underperform the markets.
Industry researchers and academicians alike have studied this phenomenon over the decades and even formed a discipline, behavioral finance, to plumb the depths of why so many investment decisions have come up short for the average investor.
Data provided by the industry research group Dalbar, Inc. show by just how much average investors are bedeviled by below average returns. Across the 20 year period through December 31, 2019 the average equity fund investor netted a market return of only 4.25%, far below the 6.06% return delivered by the S&P 500 Index.
The bulk of research in modern economics has been built on the notion that human beings are rational agents who attempt to maximize wealth while minimizing risk. A large body of empirical research however indicates that real individual investors behave differently from model investors with behaviors like these:
- Overconcentration: Many individual investors hold too many under-diversified mutual fund portfolios. This leads investors to trade too actively, speculatively, and to their detriment. Notable exception: According to DALBAR, The average technology fund investor has generally been surpassing other sector investors over the last two decades.
- Selling winners, holding onto losers: Real investors tend to sell their winning funds while holding on to their losing investments—a behavior dubbed the “disposition effect” in which tax liabilities further depress returns due to over-trading.
- Media influences: Real investors famously rush to buy the day’s just-publicized top-performing mutual fund. This type of media-based buying can lead to other bad behaviors – like trading too speculatively.
- Attention deficit: According to Dalbar, the average investor fails to stay invested in any given fund for a long enough period of time to truly realize the long-term benefits of asset ownership. Historically, retention rates increase when the market is rising and contract during market downturns.
In The Behavior of Individual Investors, by the research team Brad M. Barber and Terrance Odean, findings show that when the stock market goes up, investors put more money in it. And when it goes down, they pull money out. “This is akin to running to the mall every time the price of something goes up and then returning the merchandise when it is on sale—but you are returning it to a store that will only give you the sale price back,” says Dana Aspach CFP®. “This irrational behavior causes investor market returns to be substantially less than historical stock market returns.”
The Bottom Line
Whether falling in love with a person or a mutual fund, emotional investors are going to emote. What can be done? According to Ms. Aspach, “One of the best things you can do to protect yourself from your own natural tendency to make emotional decisions is to seek professional help and hire a financial advisor. An advisor can serve as an intermediary between you and your emotions.”
John Drachman is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. John is an IABC award-winning writer, who applies his 30 years of financial marketing experience toward advancing the dialog between investors and investment professionals.