Why do investors consistently underperform the market?

posted on April 29th, 2015 by Bellmont Research Team

Logo
When it comes to investing in shares one of the most common questions asked is why do investors consistently underperform the market? It’s always a favourite topic of the financial press who tend to put focus on the fund managers (and rightly so!) but often neglect the decisions the individual investor makes. Thankfully the question is answered clearly with the annual research paper from Dalbar – Quantitative Analysis of Investor Behaviour (QAIB). 2015 is the 21st year that Dalbar has produced the QAIB report: – A study that measures the effects of investors decisions to buy, sell and switch into and out of mutual funds (equivalent to Australian managed funds) over short and long term time frames.

What does the report show us

Dalbar do not beat around the bush when answering the question of underperformance. On the first page:

“Investment returns are more dependent on investor behaviour than on fund performance. Mutual fund investors who hold onto their investments have been more successful than those who try time the market.”

The data provides overwhelming evidence to support this claim. In every single time frame, whether short term or long term, the average investor has significantly underperformed the market. table While many investors have ‘justified’ reasons for buying and selling, the evidence is damning in showing the horrific damage they are doing to their returns by jumping in and out of the market. The impact is best understood by examining the difference in dollar terms. According to Dalbar, the average equity investor over a 30-year timeframe had returns of only 3.79% p.a., compared to the S&P500 return of 11.06% per annum. This represents an underperformance of 7.27% p.a. Based on these figures, a $100,000 investment by an average equity investor would be worth $294,111, whereas if they had invested and remained invested in the S&P500, they would’ve seen a return of $2,094,944 – an astonishing difference of $1,800,834!!! AverageEquityInvestorVSSP500

What can we learn from this study?

The Dalbar study highlights two key areas which are contributing to investor underperformance.

  1. Irrational decision making
  2. Not being invested for a long enough period of time

1. Irrational decision making

“Investor behaviour is not simply buying and selling at the wrong time, it is the physiological traps, triggers and misconceptions that cause investors to act irrationally. That irrationality leads to buying and selling at the wrong time which leads to underperformance.”

We are all human and suffer from behavioural biases which affect our decision making. “I shouldn’t eat McDonalds for lunch” yet we go ahead and do it anyway. While it can be easy to recognise these small irrational decisions (normally 30 minutes after we have eaten our Big Mac we start to regret our decision) it can be much harder when it comes to investing. What we have to recognise, however, is that we do suffer from these behavioural biases.

Some of the biases Dalbar elude to include:

  • Loss Aversion – Expecting to find high returns with low risk
  • Narrow Framing – Making decisions without considering all implications
  • Anchoring – Relating to familiar experience even when inappropriate. Ie. I made money investing in BHP last time, I will invest a large amount in that company again.
  • Mental Accounting – Taking undue risk in one area and avoiding rational risk in others
  • Herding – Copy the behaviour of others
  • Media Response – Tendency to react to news without reasonable examination (linked closely to herding)

This recognition of behavioural biases in investing has lead to some excellent research on the topic of behavioural finance. While this is another topic for another day, as investors we must understand that we all, even professionals, suffer from these biases. This is core to Bellmont’s investment philosophy and why we adopt systematic approach to our portfolio construction rather than being subject to the fallibility of individual portfolio managers.

2. Not being invested for a long enough period of time

One thing that all the negative behaviours have in common is that they can lead investors to deviate from a sound investment strategy that was previously established on their goals, risk tolerance and time horizon. The data shows that the average mutual fund investor has not stayed invested for a long enough period of time to reap the rewards that the market can offer a more disciplined investor.

Working for a portfolio manager I am often engaged in the debate of property vs shares, it’s a great Australian pastime of pitting the two investment classes against each other. The most common analysis people refer to is the family home, ‘I purchased my home 25 years ago for $150,000 and it’s now worth $750,000…’ end of debate. I am quick to point out however that this analysis misses the point. Their analysis is not a reflection of what asset class has superior returns, it’s a reflection of time invested in that asset. The average Australian has done well in property because they have remained invested for the long term. Yet when it comes to investing in shares Dalbar reports that the average time of investment is only four years. When investing in shares all of a sudden short term movements are monitored intensely and emotion starts to override rational decision making. This is reflected in the data that shows that most investors withdraw their money from the market after it has fallen, this is usually when fear is at it’s highest. They then invest money when the market is at it’s highest, this is usually when euphoria is at it’s greatest. Essentially investors are buying high and selling low, the complete opposite to what they are trying to achieve and hence why there is such larger deviations from the average investors return and the return of the overall market. At Bellmont we do not profess to have a crystal ball which helps us to time the market, providing our clients with superior returns. To the contrary we believe the evidence is clear (through Dalbar and years of other academic research) that it is impossible to consistently time the market. Rather through disciplined long term investing via a systematic approach, we help our clients achieve successful long term returns through the course of all market cycles.

Conclusion

Why do investors consistently underperform the market? Unfortunately investors tend to be their own worst enemy. Our behavioural biases lead to irrational decision making, resulting in short term market guessing. The end result is an astonishing amount of money is left on table. As investors (Bellmont included!) we have to be aware of these issues and ensure we do not fall into the same trap. – This article was written by Simon Bylsma A full copy of the DALBAR study is available for download by clicking here.



New Trading Platform

Bellmont is delighted to announce a new online trading platform will be launching in July 2014 alongside our existing Prime platform.

    Trade Overseas Stocks & CFDs
    Trade ASX Stocks & CFDs
    Trade FX Currencies
    Low Cost Brokerage
    Mobile Trading Platform