Why do many individuals fail to achieve investment returns that are anywhere near the returns posted by the mutual funds in which they invest? In the words of comic-strip sage Pogo Possum, “We have met the enemy, and he is us.”
People have behavioral quirks that often get in the way of their own success. For the past 22 years, Dalbar, Inc., a consulting firm, has published “Quantitative Analysis of Investor Behavior” to measure this impact. Dalbar’s analysis concludes that the returns achieved by average stock mutual fund investors over time are only about 50 percent of the returns achieved by the market (represented by the Standard and Poor’s 500 stock index). Investors in bond funds did even worse. For the 10 years that ended Dec. 31, 2015, the average bond fund investor was estimated to have earned a meager 0.39 percent while the bond market (Bloomberg Barclays Aggregate Bond index) returned 4.51 percent.
There are a few well-known behaviors we need to avoid, but stepping outside one’s own mind requires a lot of discipline. The QAIB study lists nine behavioral biases, but let’s look at just a few.
First is “loss aversion.” For most people, the pain of loss far exceeds the pleasure of a similarly-sized gain. This often causes people to avoid volatile markets that may present exceptional opportunities. Many investors, burned in 2008, sat out the first several years of the recovery because they feared the pain of another drop. I saw a client sell out of stocks in the 2000 – 2001 down market and miss the entire gain from 2001 to 2006.
A second quirk is that people tend to be risk-averse with respect to gains but risk-seeking with respect to losses. Our instinctive bias is to take the sure gain, but to take a chance if it means possibly avoiding a cost.
How does this bias impact investor returns? We are biased to take profits too soon but tend to hang onto losers. How often have we heard the phrase, “I’m waiting to get even before I sell?”
Another problem bias is “recency” — the tendency to place more weight on the most recent data inputs and to presume that the future will simply be a continuation of the recent past. The “market” often assumes that once asset prices (whether stocks, bond, precious metals, or condos) start to rise or fall, they will continue on the same path so for an extended period.
Recency can lead to poor decisions with respect to short-term market timing. Data on flows into and out of mutual funds show than much of the time, investors sell when the prior month return was negative and buy when the prior month return was positive. When markets have abrupt reversals, as happened in early 2016, for example, this was the exact opposite of the most strategic action.
How can we step away from these behaviors? There are a few basic principles.
▪ Make a long-term plan: If saving and investing for retirement, take advantage of calculators and links from the Social Security Administration, AARP or the many investment fund sponsors. If your situation is more complex, you may want to consult a financial planner.
▪ Be systematic in your savings plan. If your plan is to save on a monthly basis, don’t skip any months.
▪ Rebalance your investments, but not too often. Typically bringing your proportion of stocks, bonds, and other investments back to planned targets every 3 – 6 months is sufficient.
▪ Don’t be a short-term trader. Evidence shows that this doesn’t add value.
▪ Steer clear of fads. While they seem to work for a while, they typically collapse abruptly. Stick with good fundamentals.
▪ Use a professional adviser, but ask about credentials. The primary credential for investment managers is the Chartered Financial Analyst (CFA®) designation. For planning, the primary credential is the Certified Financial Planner designation (CFP®). Credentials alone don’t guarantee results, but they are an indication of the holder’s education, training and focus on the profession.
▪ Be cautious about advisers pushing particular products rather than a strategic plan.
▪ Stay with your plan.
These steps don’t come with any guarantees, but they can help you avoid “misbehavior”.
David Kamons, CFA®, is a senior investment strategist for Wells Fargo Private Bank. Kamons, who has more than four decades of experience in investment research and portfolio management for private clients, also has an MBA from Harvard. He belongs to the CFA Society of Miami. Views expressed are those of the author, not necessarily Wells Fargo Private Bank or Wells Fargo Bank, N.A.