The results are in and the average mutual fund investor has underperformed the S&P 500 for the past 20 years. In fact, according to a report published by the Dalbar consulting firm, the average equity mutual fund investor’s average annual return over the last 20 years was only 4.67%, which is far lower than the 8.19% average annual return of the S&P 500 itself. So why does the average equity mutual fund investor underperform? Contrary to conventional wisdom the primary cause of the return gap is not the returns of the mutual funds themselves, rather it is the behavior of the investors.
The Dalbar group has been publishing its annual “Quantitative Analysis of Investor Behavior” or “QAIB” since 1994. The report seeks to understand how investors behave and why. Unfortunately, the report consistently shows that there is a gap between the performance of the market and the performance that most investors actually experience. Dalbar places the majority of the problem on investor behavior.
So what are those ‘behaviors’ that result in underperformance? Most are associated with fear and greed, but they are more than just trading at the wrong time. There are 9 key behaviors that Dalbar has identified that can plague each of us depending on our unique personalities and experience. They are as follows:
Media Response: Tendency to react to news without reasonable examination
Herding: Copying the behavior of others even in the face of unfavorable outcomes
Loss Aversion: expecting to find high returns with low risk
Mental Accounting: Taking undue risk in one area and avoiding rational risk in another
Improper diversification: Seeking to reduce risk but simply using different sources
Anchoring: Relating to the familiar experiences, even when inappropriate
Regret: Treating errors of commission more seriously than errors of omission
Optimism: Belief that good things happen to me and bad things happen to others
Narrow Framing: Making decisions without considering the implications
All of us have been guilty at one time or another of one of these errors. It is easy to fall into the trap of poor decision making, especially when our decisions are not anchored in a core investment strategy and discipline. Therefore, we continue to believe that the best approach is to have a clear philosophy, sound strategy, and consistent disciplined approach. The commonality of all of these investing errors is that they cause us to deviate from that discipline - investor beware!