By: Julio Cacho, PhD & Juan Carlos Herrera
In our previous blogs, we have provided theoretical and empirical evidence that broad-based indices outperform most active managers (see here, here and here). In this blog, we argue that the average investor in the U.S. significantly underperforms broad-based indices. Dalbar’s (2017 QAIB Report) analysis shows that the 30-year annualized S&P 500 return was 10.16% while the 30-year annualized return for the average S&P500 investor was only 3.98% -- a gap of 6.18% annualized.
30-year annualized returns
Investors try to time the market. Research strongly suggests that investors lack patience and long-term visions to stay in any one fund for much more than four years. Investors tend to jump into and out of investments every few years. This strategy is not prudent because most investors are simply unable to correctly time when to make such moves.
These results imply that the returns of the average investor are more dependent on investor’s behavior than on the index performance. So, why do investors try to time the market? You might be surprised to know that a lot of the failures of financial markets are due to certain psychological factors that affect an individual’s actions. Investors fall into psychological traps, triggers, and misconceptions that cause them to act irrationally. That irrationality leads to buying and selling at the wrong time, which leads to underperformance.
One irrational behavior, for example, is called herding. This is simply the behavior of copying someone else’s actions, even when unfavorable outcomes seem obvious. Another common behavior is anchoring, or relating something to an experience you’re familiar with even if it is inappropriate for the given situation. Over-optimism, the belief that good things happen to me and bad things happen to others, is another behavioral bias. These behavioral biases are very real. Even savvy business people can fall prey to them if they go into investing without all the right advice. Investors must be aware of these results and behavioral biases to stay on track for their long-term investment goals.