Why DIY Results Lag Behind Market Performance

Once again last year, investors’ gains lagged well behind average market returns. And once again, the cause was poor investment management decisions.

Reaching findings consistent with a longstanding pattern, a recent study by DALBAR, a well-regarded advisory research firm, found that investors’ returns were significantly lower than the market’s in 2018. While the S&P 500 dipped 4.38%, the average stock fund investor lost more than twice that amount—9.42%. These investors were “blown away by the market turmoil,” DALBAR stated when releasing the study in late March.

How DIY investors can lag behind

Common among investors’ errors was darting in and out of the market instead of staying in it consistently. All too often, investors become afraid when the market drops and sell low, and then get back in when it comes up, buying high. And while they’re out of the market, they miss out on the few up days that can make a huge difference over time.The DALBAR study echoes the findings of numerous studies showing inferior results stemming from poor investment decisions. Among them was a 10-year study from Morningstar finding that the average fund investor lagged behind average fund returns.

Beyond just a lack of basic investing knowledge and information, the cause of this disparity for many individual investors is mistakes stemming over-confidence and irrational biases. Though these mistakes cost them plenty in missed returns, many individual investors are acutely concerned with saving on investing costs, so they choose not to hire advisors.

Considering the findings of the DALBAR and other studies, such highly cost-averse investors are clearly pennywise because, in many cases, getting professional advice and investment management may improve their net returns. Of course, the results obtained by some advisors also fall short of the market. But many others (with good credentials) produce much better results in the long run, especially if they insist that their clients’ hold well-diversified portfolios. Individuals who reject professional advice to save money tend to believe they can do just as well on their own.

Various studies have demonstrated this over-confidence, including landmark research by Terrance Odean, a finance professor at the University of California who focuses on behavioral finance, which is the human elements of financial decision making. Odean found that overconfidence in investing stems from over-confidence in general, especially among men. Single men tracked in one study traded 67% more than single women, with inferior results, Odean found, generating widespread publicity focusing on his conclusion that, by this measure, women tend to be better investors. Part and parcel of trading too much is a tendency to dart in and out of the market, incurring losses.

Various behavioral finance studies have shown that losses are highly impactful psychologically for investors, perhaps more so than gains. The prospect of loss—loss aversion--has been shown for decades to be a dominant motivator of investor behavior.

When the market is headed down, fear of loss prompts people to sell, so they end up selling low. This is irrational because the whole idea of maintaining a long-term portfolio is to take out gains gradually—preferably, when the market’s up--as needed to pay expenses in retirement, rather than liquidating rashly in reaction to an episodic market event, when the values may be down.

These investors also hurt themselves by operating under recency bias, a common cognitive bias shown to account for error-prone behavior. Recency bias drives the assumption that an investment’s future performance is likely to resemble its recent past. Investing this way is actually illogical because, if a stock has been doing well its price has been bid up, meaning that there may not be much room for growth.

And in terms of scientific statistical probability, a stock’s future performance is most likely to resume its long-term past average—not its recent past performance. (This is known as reversion to the mean.) By investing in a stock only because it has gone up recently, you’re likely setting yourself up for a loss.

Takeaway

This is like driving while looking strictly in the rear-view mirror. The idea is to focus on factors coming at you, rather than those behind you. This isn’t to say that it’s categorically unwise to invest in stocks that have been doing well lately. It’s just that investors should have reasons that support the case for future growth.Such concepts aren’t widely understood by individual investors, who don’t have professional market backgrounds. This isn’t to say that some investors with the right educational backgrounds, given enough motivation, time and access to research data, can’t make sound decisions. But most people can’t do this at a high level. Instead, they’re focused on making a living—a strong reason to be careful with their hard-earned money by seeking professional guidance in what is an increasingly specialized technical field.

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David Robinson, a Certified Financial Planner, is founder/CEO of RTS Private Wealth Management, an SEC-registered firm in Phoenix that provides fiduciary services to help clients achieve their financial goals. His practice focuses on helping wealthy individuals with custom financial plans, using a holistic approach to grow/protect wealth, manage taxes, identify insurance solutions, prepare for retirement and manage estate plans.