Why are Individual Investors so Bad at Investing?

Individual Investors Need Help

Individual investors as a group have no idea what they are doing. This has been made clear by a recent DALBAR study spanning 30 years all the way back to 1984.1 This period covers a number of bull and bear markets, giving investors a chance to learn from their mistakes. However it is clear that they are not learning the lessons of proper investing.

Individual Investors

The S&P 500 is one of the most widely followed indices and is considered a benchmark for the US stock market. I would consider it a suitable benchmark for this study. These numbers compiled by DALBAR show that the return of the S&P 500 over the 30 year period ending in December 2013 is 11.11%. They also show that individual investors only measured 3.69% over that same period of time. This is a remarkable 7.42% difference annually. To put this in perspective, if you invested $100,000 in 1984 in the S&P 500 and earned 11.11%, today (30 years later) you would have $2,358,275. If you started with $100,000 and invested it over the same time period at 3.69%, you would have $296,556. That is a difference of $2,061,719. It should be clear from these numbers that individual investors have a problem.

Why do individual investors perform so poorly?

What is not clear from this study is why individual investors have a problem. Some people suggest that it is because investors are not learning, despite all the education currently available to them. While this might be true, I think the problems go deeper than that. Fidelity Investments conducted a study on their Magellan fund from 1977-1990, during Peter Lynch’s tenure.2 His average annual return during this period was 29%. This is a remarkable return over the 13 year period. He was easily one of the best performing fund managers for his asset class. It should be noted that this was not a secret. Fidelity’s Magellan fund became one of the largest mutual funds due to its success under Peter Lynch, so it is clear that investors were aware of its performance. Whether the investors in the fund were chasing performance or investing due to his expertise is unclear. What is clear is that investors learned that Peter Lynch was investing in a method that worked.

Given all that, you would expect that the investors in his fund made substantial returns over that period. However, what Fidelity Investments found in their study was shocking. The average investor in the fund actually lost money. You read that correctly… The average investor lost money in the Fidelity Magellan fund under Peter Lynch’s tenure during a period of time when the fund returned around 29% annually. So if investors can learn enough to find good investments, why do they consistently perform poorly with their investments?

Human Psychology

Individuals make decisions everyday with their emotions assisting their judgment. It is part of who we are as human beings. Unfortunately making emotional decisions can be a detriment in the investing world. Individual investors who let their emotions guide them have a much harder time investing than people who have found ways to master their emotional decision making. Some investors try to master their emotional involvement by using a rules-based system, others use computers to make the decisions for them, and still others invest in indexes through ETFs or mutual funds. There are many ways to remove the emotional component from investing, but most investors don’t realize that their emotions are the problem. You can read my post about fear and greed investing or investing is not gambling to learn more.

Performance chasing

Performance chasing

Investors who chase performance are highly likely to lose money over the long term. This is not because investing in top performers is a bad strategy. It is because in many cases these investors are not doing any research. All they are doing is looking at a list of mutual funds in their 401k plan and choosing the one or few that are performing the best and putting their money there. Given the highly complex nature of investing, it should be obvious why this does not work. Individual investors should always know where this money is being invested and why they are investing in that asset.

 

Casino Investing

Casino Investing

Many people think they can make money by winning the lottery. If it was easy, then everyone would be a millionaire. Playing the lottery is a tax on people who are bad at math. It is appealing that a little money can turn into a lot of money, however the odds are highly stacked against you. You can read my post about investing is not gambling.

Part of the casino mentality is based on “having fun” with their investments. Investing should not be fun, it should be treated as work. If you are “having fun” with your investing, then you are doing something wrong. Learning about investing can be fun, but the investing itself should be done in an emotionless fashion if someone wants to be successful at it.

The “me too” lemming investment strategy

me too investing

This is a common strategy of people who don’t know what they are doing with their investments. For example, let’s say you have a 401k plan at your company and you don’t know how you should allocate it. You might decide to ask one of your coworkers what he or she is investing in. If you don’t know anything, then how could they possibly know less than you. This happens more than it should. Although it is possible their coworker is a savvy investor, the odds are against it. It is more likely that the co-worker you asked, found his or her allocation from another co-worker.

Another example of this is friends or acquaintances comparing their returns to each other. While one person might have significant returns compared to the other, the person with lesser returns might decide to invest the same way as his friend. This rarely works out. While an investment strategy might work for one person, it may not make sense for someone else. This is also a poor form of investing.

Fear and Greed Investing

Fear and Greed

This is one of the biggest reasons for individual investor under-performance. The study done by Fidelity Investments should highlight this. Investors in one of the most successful mutual funds lost money during a period of time where the fund made 29% annually. According to Fidelity, investors would pull their money out of the fund during periods of poor performance, and send it in during good periods. While fear might have saved us from getting eaten by a tiger in prehistoric times, it is detrimental to our investing performance. Read more about this in my Fear and Greed investing post.

The odds are against you

A 25 year study done by Longboard Asset Management which looked at 3000 stocks (Russell 3000) from 1983 to 2007 showed that the odds are against you for randomly picking winning stocks.3 The study showed that:

  • 18.5% lost at least 75% of their value
  • 39% of the stocks lost money during the period
  • 64% of the stocks under-performed the Russell 3000
  • Only 25% of the stocks were responsible for all the market’s gains

This shows that if an investor knew nothing at all and picked stocks at random, they would most likely under-perform the index. This is not surprising considering other the studies showed similar results. If the odds are stacked against the individual investor, what should they do?

If the odds are against me investing successfully, what should I do?

It should be clear that individual investors are, on average, not good at investing. This is compounded by the low odds of randomly picking successful stocks. Here are some ways investors can improve on their returns.

  1. Invest in an index – Investing in an index will provide you with returns of that index, minus the expenses of that index. There have been many studies done which show that index investing is the best method of investing and that most actively managed funds under-perform their comparable index. While there are reasons for this (see my post on career risk (add link)), it is important to compare your investment choices to an index. The index is considered the average, and if someone is not a savvy investor, then being average by investing in an index may not be a bad strategy. If the average investor under-performs the index, then it pays to be average. Successful investors such as Berkshire’s Warren Buffett, or Bridgewater’s Ray Dalio have publicly stated that if something happens to them, they would suggest that their heirs invest in an index rather than seeking a new strategy for their inheritance. If it is good enough for the most successful investors of our time then it might be good enough for you.
  2. Have a rules based investing approach – Many professionals use a rules based investing approach to define their investment strategy. Examples of this might be using a stop loss, not investing more than 5% in any one investment, or only investing in an asset which meets certain technical or fundamental criteria. The reason that professionals use rules based investing is that they are human too. They also are controlled by their emotions and find it hard to make rational choices in every situation. Warren Buffett made a statement about his early years in that he moved far away from New York because it was easy to lose perspective and living in Omaha help him think clearly about investing. Adding stop losses to an investing strategy is one of the most statistically significant rules-based approaches an investor can use. While buying at the right price is one of the most important components of investing, knowing when to sell is one of the hardest. Stop losses help investors remove that emotional decision.
  3. Use computers to remove the emotions of investing – Computers have significantly improved the process of investing. They allow investors to quickly access all the research available, actively view chart patterns, and buy and sell in the blink of an eye. These things are vast improvements over the old way to doing things. However, one of the most important improvements to investing stemming from computers is the ability to program the computer to use a strategy without human involvement. This lets the computer do the work to remove the emotional decision making ability from the individual. Some very successful fund managers use this strategy, while others combine this approach with minimal human involvement.
  4. Work with a professional – Using a professional wealth manager is one of the easiest methods of improving investor performance. This choice can remove the emotional attachment you have from your investments. Professional wealth managers have the time and experience to help institute an investment plan and stick to a specific strategy. Most importantly, the wealth manager can help talk you off the ledge during a poor performing period of the market, when the average investor would be selling his investments rather than investing additional funds.

The emotional component of investing is what makes it such a challenging endeavor

Having a professional help you with your investing is important if you want to improve your performance. Even successful investors have sounding-boards and devil’s advocates to help improve on an investment strategy or thesis. At Innovative Advisory Group we work with our clients in different capacities, from full-discretionary authority to just providing a contrarian opinion to help formulate a proper strategy. We can work with you to help add value to your investment strategy. If you want to consider how we might be able to help you improve your long term performance, contact us to learn more.

 


References:
  1. Dalbar
  2. Fidelity Investments
  3. Longboard Asset Management

 

About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that we have an extensive understanding of the regulatory and financial considerations involved with self directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources.

For more information you can visit www.innovativewealth.com

About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and non-traditional investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.

Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.