Humans experience emotion – it’s a biological fact. And when it comes to money, science shows that our emotions can be quite powerful. Unfortunately, those emotions can drive short-term thinking and erratic investing choices.
A 2014 Dalbar study (summary here) finds that the average investor in all U.S. stock funds earned 5.19% over the past 20 years—a period in which the S&P 500 stock index returned 9.85%, almost twice the return of individual investors! Stock-fund investors underperformed the market by 4.66 percentage points over two decades.
Dalbar, a financial research firm in Boston, has updated its oft-cited study each year since it published its first in 1994. The comparative returns for 2014 were dramatic and telling, both for equities and fixed income:
- STOCKS: The average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. The broader market return was more than double the average equity mutual fund investor’s return (13.69% vs. 5.50%).
- BONDS: In 2014, the average fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by a margin of 4.81%. The broader bond market returned over five times that of the average fixed income mutual fund investor (5.97% vs. 1.16%).
This gap in returns is called Behavior Gap, a phrase coined by Carl Richards, who quipped, “Investments don’t make mistakes, investors do!”
How is that possible? The human factor helps explain these lower returns. Investors chase returns – jumping in the market after a streak of hot performance and selling out after it drops. It’s clear from the data above that even buying and holding an index for a long time can be a pretty decent strategy. But real people don’t invest that way. We trade. Because of our “buy-high, sell-low” behavior, investors in the typical fund earn lower average returns than the fund itself.
While Dalbar’s study is not without its critics – those who argue that investors aren’t as dumb as the study suggests – it’s hard to argue with 20 years of data. We believe the impact of emotional investing is undeniable. It’s not a question of being smart; many intelligent investors have had their decision-making hijacked by their emotions. That’s why at GV, we’ve built a team-based, process-driven investing system designed to help us (and our clients) mitigate stress and emotional decision-making that can derail a disciplined, long-term investment strategy. Because if you expect a strategy to work, you need to stick with it.
Image source: Carl Richards, Behavior Gap