The track record of Individual investors is grim. This topic comes up every year when DALBAR releases a study1 tracking investor behavior over the past two decades, which included the dot.com bubble, the Great Recession, and the recent return to bullish markets. However, that depth of hindsight is not creating a 20/20 of wise investments. These annual studies repeatedly show investment lessons are not being learned.
In 2017, the average equity mutual fund investor under-performed against the S&P 500 Index by a margin of 4.7%. That poor performance against the market is part for the course: The 20-year annualized S&P 500 return was 7.68%, while the average equity fund investor earned a market return of only 4.87%.
The Poor Performance of Individual Investors
The data shows poor results, but offers no one explanation for the poor performance of individual investors. It would appear investors are not learning from past mistakes despite the wealth of financial advice available. Even some of history’s best investments don’t hold up under scrutiny.
From 1977-1990, Fidelity Investments’ Magellan fund run by Peter Lynch created an average annual return of 29%, nearly double the 15% return for the S&P 500. That return rate was one of the best in its asset class and investors looking for a ‘sure thing’ flocked to the Magellan fund, making it the largest mutual fund. However, a Fidelity Investments study found that despite the fund’s returns over Lynch’s tenure, the average investor lost money.
That’s right; few of the investors saw those robust 29% returns. The fund was opened to the public in 1981, after Lynch established a four-year track record of exceptional returns. From 1981 to 1990, the average Magellan investor earned an average annual return of 13.4%, which lagged behind even the S&P 500’s 16.2% return during that same time.2
It’s perhaps the biggest lesson in investing: timing is everything. Those lucky enough to invest during the incubation period prior to 1981 saw a great deal of growth in a small amount of capital. When the public began to pick “the best” mutual fund and dogpile onto its outperformance, the fund was already returning less stellar percentages. Furthering the problem, many investors withdrew money from the fund during rough patches, and returned to it when its performance returned. Once Lynch retired, the Magellan’s performance stalled, and investors went chasing the next “best” fund. In recent years, the Magellan fund has rebounded under the tenure of Jeff Feingold.3
The mythical status of the fund, and its sheer size, make it a great example for exploring common investment pitfalls. Below are some of the interrelated reasons individual investors find themselves losing to the market.
A common trigger for investors is financial news. Psychologist Paul Andreassen’s experiments in investor behavior in the 1980s led him to conclude that “paying close attention to financial news can lead investors to trade too much and to earn lower returns than those who tune out the news.”4
Since then there are financial TV networks, podcasts, and hundreds of websites, but these haven’t changed the behavior of individual investors much. In fact, the early rise of 24-hour financial news and the ability to watch the markets in real time from a home computer lead to a boom of day-trading in the early 1990s, most of who paid dearly as they learned lessons in volatility and trade fees.
The best advice for long-term investors may be this: don’t follow the financial reporting in the daily news. By the time you have heard it or read it on the news, the market has already been adjusting itself. Another aspect is differentiating news reports of what happened from predictive opinions, which often get more press, but vary wildly.
Individuals make irrational decisions every day; it’s a part of human nature. Allowing emotions and impulses to influence financial decisions is a leading cause for poor investment performance. Individual investors who let their emotions guide them have a much harder time investing than people who have found ways to master their emotional decision making.
To avoid emotional investing, some investors use a rules-based system or a computer program to make sure they are following their initial investment rules. Others invest in indexes (which we’ll address later) to avoid chasing funds with headline-making managers. The important lesson here is that they prevent themselves from emotional investment by eliminating, a hands-off approach that’s less prone to chasing the best performers and poorly-timed investments.
Delusions of Grandeur
The promise of a big payout excites the brain. Investors can easily slip from patient investment strategies that pay off over the long-term, to deciding on a more aggressive strategy in the short-term. This desire to “roll the dice” is another form of emotional investing, and akin to gambling.
If you think about it, investing is the exact opposite of gambling. Gamblers who play for fun usually allocate an amount they are willing to lose before they enter a casino, (wisely) expecting to lose, and justifying it as entertainment. Investors should allocate funds expecting an eventual return and expect the process to be mundane, if not boring.
Some investors are mostly passive investors, like those who are thrown into the investment world by their employer’s 401k plan. These investors get a job that’s finally offering a financial investment, but they haven’t researched lessons on investing much less how they should allocate their money. They may consult a coworker or manager who has been with the company longer, or a family member who has bragged about good investment performance before, and invest in the same assets. But what’s good for the goose isn’t good for the gander, and this leads to investing strategies based on other people’s needs instead of your own.
Similarly, individual investors will go it alone, without research, and simply pick a high performance mutual fund and set their 401k plan on autopilot. Investing is complex and dynamic, so it should be obvious why this hands-off approach does not work. Individual investors should know where their money is going and know the rationale behind that asset.
Other Options for Individual Investors
It’s clear that the average investor is prone to one or more of the pitfalls listed above. To avoid this, and learn from these lessons, individual investors should consider other options.
Invest in an index – Recent studies have fueled the move from active investing toward passive investing in indexes. The market’s behavior since the 2008 crisis still casts a shadow of doubt on active stock managers, and rightly so. Index funds consistently outperform actively managed funds. A 2016 study by S&P Dow Jones Indices showed that 90 percent of these managers fail to beat their targets over one-year and 10-year periods.6
One reason active investing often underperforms for individual investors is due to the fees associated with each trade transaction. Index funds are typically slow growth and low-fee investments ideal for retirement accounts. Instead of asking your coworker in accounting where they invest, take the advice of Warren Buffett, who recently told CNBC’s On The Money “Costs really matter in investments. If returns are going to be 7 or 8 percent and you’re paying 1 percent for fees, that makes an enormous difference in how much money you’re going to have in retirement.”7
Rules-based investing – This strategy is to protect you from yourself. Establishing well-defined goals is the first step to shaping an investment strategy and sticking to them requires patience and discipline. Many investors create rules to prevent emotional, kneejerk reactions to market fluctuations (that terrible tendency to “sell low, buy high”).
Common rules can include capping one investment at a set percentage, using a robo-advisor to periodically re-balance your portfolio, and separate sell rules to secure profits and prevent excessive losses. Adding stop loss rules may be the most important, because it removes the complex emotions attached to selling off.
Setting investment rules for yourself can work, but the best way to avoid breaking your own rules is the use of a computer program. Letting the computer follow your set parameters will allow you to take a more hands-off approach which will alleviate stress while statistically improving your investment performance.
Professional Guidance – Seeking the advice of a financial wealth manager is one of the easiest ways to improve the performance of your investment. Leaving it to the experts removes your own emotional attachment and avoids the common mistakes made by individual investors.
A wealth manager can not only help you with your investing and is an important check on your own impulses, but also a partner in building toward retirement. iWealth was created to help you manage risk while you invest wisely and live well. We have built our firm around long-term relationships and maintain our industry-leading technology to help you stay ahead of the game. If you are considering a new investment strategy with an eye on performance into retirement, contact us to learn more.
Securities and Advisory Services offered through LPL Financial, a Registered Investment Advisor. Member FINRA/SIPC. Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Dalbar’s Quantitative Analysis of Investor Behavior. https://www.dalbar.com/QAIB/Index
“Lessons from a Great Fund Manger’s Record,” Nathan Hale. https://www.cbsnews.com/news/lessons-from-a-great-fund-managers-record/
“A Once-Hot Fidelity Fund Is Outperforming Again. Investors Still Don’t Care,” by Charles Stein. https://www.bloomberg.com/news/articles/2018-06-04/fidelity-magellan-fund-has-made-a-comeback-investors-don-t-care
“Judgmental extrapolation and market overreaction: On the use and disuse of news,” Paul B. Andreassen. https://onlinelibrary.wiley.com/doi/abs/10.1002/bdm.3960030302
“Active vs. Passive Investing,” https://www.bloomberg.com/quicktake/active-vs-passive-investing
S&P Global SPIVA Scorecard. https://www.spglobal.com/en/research-insights/articles/SPIVA-US-Scorecard
“Warren Buffett just won a $1 million bet—and highlighted one of the best ways to grow wealth,” Emmie Martin. https://www.cnbc.com/2018/01/03/why-warren-buffett-says-index-funds-are-the-best-investment.html