If market volatility is keeping you awake at night, there’s an even more insidious danger lurking in the shadows. Dalbar Inc., a research company that studies investor behaviour and analyzes market returns, undertook a study to understand a recurring phenomenon: why do investor returns consistently under-perform investment returns?
Studies show that an enduring failure for investors is to reap the full benefits offered by the most common of market indices. The graph below shows their findings, clearly comparing the performance of the benchmark S&P 500 relative to investor returns over the same investment window.
With the statistics showing such consistent disparity between the two sets of experience, the obvious question is ‘why?’
Given that investors across North America have unrestricted access to the investments represented in the S&P 500, what would account for such underwhelming investor outcomes?
Perhaps it’s the nature of equity investments? Nope. Investor returns from fixed income funds revealed a similar mis-match when put up against Bloomberg Barclays Aggregate Bond Index. While investors averaged a lean 10-year average of 0.4%, the index delivered a respectable 3.97% annual average.
So, if it’s not the nature of the investment, and fees accounting for only a nominal difference, how is the discrepancy explained?
Turns out the real culprit is investor behaviour.
As markets rise and fall – sometimes in a more gentle ebb and flow, but more often in a more dramatic saw-tooth pattern – investor reaction too often leads to long-term decisions based on short-term circumstances. When the market displays sharp rises, our fear-of-missing-out (FOMO) tempts us to want to jump on the wagon and accelerate deposits. When the trend reverses and starts to fall, we tend to fear the sky is falling and succumb to the temptation to abandon our previous investment strategy in favour of what we perceive as safer territories.
As investors oscillate between fear and greed, it’s easy to fall into mistakes that will prove costly over time.
1. Over-reacting: Time IN the market is more important than timING the market. As the graph above points out, investors would have been far better served had they stayed invested consistently throughout the investment cycles. Because inflection points in the market are observed only through the rear-view mirror, being out of the market when these inflections occur is costly. Studies repeatedly show that being on the sidelines during key dates through the cycle when the market turns can have a dramatic impact on investor outcomes.
2. Buying high: Study after study shows that as the market goes up, investors put more money in it; when it goes down, we tend to pull our money out. This is akin to running to the mall every time the price of something goes up and then returning the merchandise when it is on sale – but you are returning it to a store that will only give you the sale price back. Obviously, this will have an impact on rates of investor return.
How do investors avoid these traps?
Here are some simple strategies:
1. Do nothing: the decision to do nothing is still a strategic decision. We are prone to want to act when often the right decision is to think… kind of a fire, ready, aim approach to a change in the situation. However, first, give thought to your goals: have they changed? If not, staying the course is most often the best response.
2. Use Dollar-cost Averaging to your advantage: This is the discipline of depositing a predetermined amount on a predetermined frequency into a predetermined portfolio. In so doing, your deposits are purchasing more shares or units when the price is lower, and fewer when the price is higher. Over time, this strategy reduces the average cost per share or unit in your portfolio.
3. Avoid selling equities in a down market: If your portfolio is allocated correctly, you should never have to sell equities at a low. Even if you are drawing income, using a cash wedge (an approach where the funding of future income payments is pooled in a fixed income portion of the portfolio) will allow you to hold on to your equities, giving them the necessary time for recovery.
As you can see, most of these tips involve staying focused on the longer-term picture.
As expressed by economist Gene Fama Jr.,
“Your money is like a bar of soap. The more you handle it, the less you’ll have.”
Perhaps these considerations have sparked questions. Feel free to contact us. We’re here to assist in whatever way we can.
CFP, CLU, CH.F.C., CHS, MFA, CEA
Rick enjoys helping people navigate the financial issues in their lives – from managing major life events and creating strategic plans for the future to mapping their values to their financial plans. He is a big picture thinker and a compassionate human.