Human nature affects poor buy and sell decisions
May 29, 2014
Investors get a failing grade when investing their money.
Research over the past several decades has shown that they are consistently getting inferior returns on their investments. Now we have new data expressing the same old problem.
A new 30 year study in the United States compared investor returns to the underlining market in which they invested. It is surprising just how poorly their investments performed.
The U.S. stock market as measured by the S&P 500 stock index returned 11.1 per cent annually over the past 30 years. Individuals investing in U.S. stock funds earned 3.7 per year for that same time frame.
This study completed by Dalbar has been repeated every year since 1994. Dalbar is a research firm located in Boston. Results vary slightly every year, but the fundamentals are always the same.
This year’s survey shows individuals earned only 3.7 per cent annually by investing in U.S. stock funds. This was 7.4 per cent lower than the yearly growth of U.S. stocks.
A similar study has been completed in the past using Canadian data and the results are similar. Canadians are as poor at investing as our friends to the south.
There are three reasons for underperformance. Most stock funds in which they invest underperformed the market by about one per cent. Fees and expenses account for at least one additional per cent. That leaves about five per cent of annual underperformance attributed to investor behavior.
How is this possible? How can investors who are motivated to earn a good return have investments perform so significantly below the average return of the market in which they invest? This is a serious problem.
The problem is not the investments; it is the investors. We need to understand investors as human beings is needed in order to explain their dismal investment performance. Behavioral finance has taught us that most people are very poor at investing because of the normal human tendencies of fear and greed.
People wait for the stock market to appreciate in value until the “greed” factor kicks in. Then they want to participate in the rising market. Then after the stock market value declines, the same investor is overcome by fear and sells to avoid further loss.
The timing is backwards. Most people have heard of the common mistake of buying high and selling low. That should be replaced by the opposite and correct strategy of buying low and selling high.
Ilia Dichev is an accounting professor at Emory University in the United States. He has studied investment performance. The professor has explained how individuals get poor investment results. Money flows into hot markets and when the markets are down, investors get scared and leave the market.
Dichev‘s research shows from 1926 to 2002 stock investors lagged behind the stock market annually by 1.3 per cent. Surprisingly sophisticated investors including pension plans underperformed the market by at least three per cent yearly versus the hedge funds they purchased.
We have documented proof that individuals are consistently poor investors. This applies to both sophisticated and unsophisticated investors.
The challenge for every investor is to try resisting the normal human tendencies of being emotional when making investment decisions.