I recently authored an article on retail investment returns which appears on the Nasdaq website. A longer version of the article is printed below:
My plan for driving to work is simple – follow Waze. I long ago came to the conclusion that Waze can see traffic patterns I can’t, and the smart thing to do is rely upon it.
Some days, however, I just ignore Waze and follow my own instincts for no apparent reason. I will rationalize this behavior – Waze can’t anticipate changing traffic patterns, Waze doesn’t know my shortcuts, and so forth. After I have finished that morning’s commute, I inevitably regret not having stuck to Waze and commit to following it going forward. Until I don’t the next time.
This pattern of having a plan, but being unable to resist fiddling with it, is a well-known and well- researched investor phenomenon. Investors historically try to outthink the system – selling to avoid losses when they (somehow) think they know a security is likely to decline, or jumping into a security when they (somehow) think they know it is likely to increase.
The amazing element of this investment pattern is how disastrous it consistently is – retail investors as an asset class have a horrendous track record vs. almost every other over the last 20 years.
20 Year Annualized Return by Asset Class (1994-2013)
The explanation for this tepid performance is unproductive “fiddling” by retail investors – in an effort to somehow beat the system, investors wind up consistently losing to it, year after year.
Along similar lines, Morningstar has extensively studied investor underperformance within mutual funds – i.e., investors often underperform the very funds they invest in by hundreds of basis points, due to “Investors often suffer from poor timing and poor planning…many chase past performance and end up buying funds too late or selling too soon.” (Source: Morningstar)
10 Year Annualized Return by Mutual Fund Category – Funds vs. Investors in Funds (2003-2013)
What drives this universal phenomenon of investors “buying funds too late or selling too soon”?
An old investing adage is that Wall Street is driven by fear and greed.
Research into behavioral finance and psychology has added several new dimensions that go above and beyond the “fear and greed” paradigm – in this piece, I will discuss the dimensions of aversions and perceptions.
People’s economic behavior is heavily influenced by ingrained mindsets referred to as aversions, which are financial/resource-related circumstances that people seek to avoid either consciously or unconsciously. (For a fuller treatment please see our white paper on the subject here.) In seeking to avoid these circumstances, aversions can lead to fiddling behavior which erodes performance returns.
The most familiar aversion for investors will be loss aversion, which refers to the psychological fact that investors experience a dollar lost as more impactful than a dollar gained.
Loss aversion in excess, however, can lead to market mistiming – getting spooked in market declines and exiting at the bottom, and, on the flip side, waiting until “it’s safe” to get back in during the recovery and missing the ride up.
Other aversions which can affect market timing decisions include:
- Risk aversion – Investors prefer a known payoff to a greater but more volatile payoff; in times of market volatility, this aversion will push investors to favor low paying known payoffs (e.g., fixed income) to more attractive but more volatile payoffs (e.g., equities)
- Ambiguity aversion – Investors prefer a payoff in a familiar environment to a greater expected payoff in an unfamiliar environment; when equity markets become less familiar because new dynamics are operating, investors will feel the urge to take their assets to more familiar territory
The aversions above have been well documented to lead investors to make decisions that are inefficient from a pure performance perspective (although not necessarily from a utility perspective – see our aforementioned whitepaper on this subject.)
Now onto perceptions – there are several perception issues which influence financial decisions and can encourage “fiddling”, thereby reducing investor performance.
It is apparently a common belief that one can outperform or outsmart “the system” in some way, either through one’s own stock picking or in the hope of finding someone who can. The Illusory Superiority effect is a well observed phenomenon in which humans profess a belief that they possess some ability above and beyond the average man. A straightforward example of this was demonstrated by Ola Svenson (Are we all less risky and more skillful than our fellow drivers, 1981) in asking people to assess their driving ability – over 90% of U.S. drivers believe they were above average, when in reality only 50% can be.
Stock picking is by definition a zero sum game – someone is selling, and someone is buying. Both parties cannot be right about the direction of the trade. (Asset appreciation occurs in the overall market through the growth of the underlying companies, not the trading activity!) And keep in mind that there are a lot of sophisticated, smart people on both side of the incredibly high number of transactions that go on a daily basis.
But the siren’s song of being about to outthink the system is too great for many investors who will still open up trading accounts (“60 days of free trades!”) and go in and out of stocks, thinking that they have uncovered a secret sauce.
For those individual investors who recognize their own “averageness”, there is still what I would describe Illusory Superiority by Proxy – they recognize they can’t beat the market on their own, but think they can find an active manager who can. Even if the last one couldn’t, I’m going to switch my investment to a new one who can.
There is unfortunately no shortage of active managers and unique trading strategies which claim to deliver Alpha, and possibly do for some time period unpredictable in length, before falling down on the job, because there are tens of thousands of professional money managers looking at the same information and trying to do the same thing. Remember, Alpha is zero sum game – if your manager is making winning decisions, he is doing it at the expense of people who are making losing decisions. And for him or her to do that consistently, he is beating other professionals. All. The. Time.
Does that seem realistic to you? It shouldn’t. (Galleon Group found one way to deliver Alpha. A more legal way to deliver Alpha would be funds who specialize in esoteric markets or asset classes which don’t have much competition. The bottom line is in a fair game with many players, Alpha is basically impossible.)
There are so many studies demonstrating that most active managers underperform a direct investment in the market that it’s hard to pick just one – here’s a well written one by Vanguard.
Two other perception issues which can negatively impact investing are:
- Herd behavior – humans have a tendency to believe that the masses are “on to something”, and not want to be left behind. When it comes to market movements, this behavior can both encourage individual fiddling (to keep up with what everyone else is doing) and magnify the direction of market momentum, since participants keep piling on
- Anchoring – humans have a tendency to overweight the first piece of information received when making a decision. So if an investor hears a piece of positive or negative information about an investment – e.g., the market is going up, or a particular holding is about to collapse, it can be hard to “shake” that initial piece of news
To recap, investors have a tendency to underperform both the market and their chosen investments due to their fiddling. In our next piece, we will discuss techniques to manage fiddling, including both having the correct financial advice and plans along with the right selection of investment products which mitigate this apparently natural human tendency.