Monday, September 8, 2014

The Under Performance of the Common Investor Relative to the Overall Stock Market

In his 2013 and 2014 MOOC on Applied Investing, Dr. Krause, director of Marquette's Applied Investment Management (AIM) program, talked about the significant underperformance of the common investor relative to the overall stock market. 

Dr. David Krause
He made reference to Dalbar, a company which studies investor behavior and analyzes investor market returns. The results of their research consistently have shown that the average investor earns below average returns. For the twenty years ending 12/31/2013 the S&P 500 Index averaged 9.22% a year – which is an attractive historical return. The average equity fund investor earned a market return of only 5.02%.

Why is this?  Academic studies show that when the stock market goes up, retail 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. This irrational behavior causes investor market returns to be substantially less than historical stock market returns.

What would cause investors to exhibit such poor judgment? After all, at a 9% return, your money will double every eight years. Rather than chasing performance, you could simply have bought a single index fund, and earned significantly higher returns.

The problem is the human reaction, to good news or to bad news, is to overreact. This emotional reaction causes illogical investment decisions. This tendency to overreact can become even greater during times of personal uncertainty; near retirement, for example, or when the economy is bad.

The study of behavioral finance documents and labels our money-losing mind tricks with terms like recency bias and overconfidence. Despite research and education, the performance gap continues. So what can the average investor do to avoid this fate? 
Consider the following four rules:

  1. Do little or maybe even nothing. A conscious and thoughtful decision to do nothing is still a form of action. Have your financial goals changed? If your portfolio was built around your long-term goals (as it should be), a short-term change in markets shouldn't matter.
  2. Hands off. To quote Dr. Eugene Fama, the famed University of Chicago financial economist, “Your money is like soap. The more you handle it, the less you’ll have.”
  3. Never sell equities in a down market. If your funds are allocated correctly, you should never have a need to sell equities during a down market cycle. This holds true even if you are taking income. Just as you wouldn’t run out and put a for sale sign on your home when the housing market turns south, don’t be rash to sell equities when the stock market goes through a bear market cycle. Wait it out.
  4. Science works. It’s been academically proven that a disciplined approach to investing delivers higher market returns. Yeah, it’s boring; but it works. If you don't have a discipline, you probably shouldn't be managing your own investments.