Humans are wired to be successful at lots of activities. We’re highly skilled at things like survival, reproduction, and social interaction. But figuring out the best way to invest our life savings isn’t our strong suit.
The same instincts that make us good at survival, like herding and fleeing from predators for example, also make us bad at investing in the stock market. The proof is in the numbers.
In its recently released Quantitative Analysis of Investor Behavior, research firm Dalbar Inc. points out that while the S&P 500 returned 13.7% in 2014, the average equity mutual fund investor gained a mere 5.5%. And while the Barclays Aggregate Bond Index was gaining nearly 6%, the average fixed income mutual fund investor was gaining just 1.2%.
While those 2014 results were pretty bad, they’re just part of a long-term pattern of investors under-performing the market by wide margins. Over the past 30 years, the S&P 500 has returned 11.1% annualized, while the average equity mutual fund investor has gained just 3.8%, according to Dalbar. Returns for bond investors have been even worse. Over the past 3 decades, the Barclays bond index has averaged annualized returns of 7.4%; but investors in bond mutual funds only managed to squeak by with an average annual gain of just 0.7%.
According to the researchers at Dalbar, the main culprit for individual investors’ terrible collective performance is behavior. “Investor behavior is not simply buying and selling at the wrong time, it is the psychological traps, triggers and misconceptions that cause investors to act irrationally,” the report says. “That irrationality leads to the buying and selling at the wrong time, which leads to under-performance.”
Here are some of the most common traps that investors fall into, taken from Dalbar study and from behavioral finance luminary Richard Thaler’s Advances in Behavioral Finance, Volume 2.
Hindsight Bias: This is the tendency of people to convince themselves that they predicted an outcome before it happened, even when they really didn’t. This hurts decision making because it can make you overconfident in your predictive abilities. That overconfidence then leads to behavior mistakes like trading too much, taking unnecessary risks, and hanging on to losing positions too long.
Mental Accounting: This is when someone takes a big risk in one area, and then tries to compensate by not taking any risk in other areas, Dalbar says. You end up with “lumpy” results because you have not balanced the types of risk you’re taking in your portfolio.
Fear of Regret: Regret is an incredibly painful thing, and because we fear it, Dalbar says investors treat errors of commission more seriously than errors of omission. For example, you buy a stock and it falls in price. Its fundamentals and balance sheet also deteriorate, to the point that it’s no longer a good stock to own. Cash out and take the loss, and you’ll have to deal with feeling regret over buying the stock in the first place — an error of commission. So instead you hang onto the stock, hoping that it will bounce back. Not selling is an error of omission that likely is worse, but many investors do just that because they fear dealing with the finality and regret of locking in the loss.
Confirmation Bias: Studies show that people are more likely to look for facts and data that support their initial thesis than they are to find evidence to refute it. If you have a good feeling about a stock, you’re likely to focus on information that supports that feeling.
What To Do: These biases tend to cause the most trouble when markets get turbulent. And when the market gets rocky, mistakes are easy to make. How do you avoid falling into these traps? The best way I know of is by having an investment policy statement, including your trading rules for dealing with market downturns, before the market starts to get too rocky. The more you prepare for turbulent times, the less likely you are to panic when trouble begins.
When times get tough and the market starts falling, having a plan in place with exit strategies and trading rules will help you focus on the long-term and not get swayed by stress or emotion. Emotion and behavior biases can also take over when you’re dealing with an undiversified portfolio. If you have too much of your money invested in just a few positions, losses can add up quickly. It’s far better to have your money spread out over many different types of investments. That way, if something you own gets really trashed, chances are that other things in your portfolio will come to the rescue.