A study of 70,000 investor portfolios showed that in 2016 investor returns lagged the market by a whopping 7%! Yes, the average investor gained 5% but the S&P 500 returned 12% over the same period. Why? Well, here are 5 reasons your investments might be performing below average.
It’s part of the behavior gap
Financial advisor Carl Richards coined the phrase behavior gap. In fact, he even wrote a book of the same title: The Behavior Gap: Simple Ways to Stop Doing Dump Things With Money. One of the key premises of the book is that investOR returns consistently fall behind investMENT returns.
The reason? Investor behavior – hence the phrase behavior gap.
How bad is it?
Research company Dalbar completed a study in 2015* which showed that the average investor return over the 20 years leading up to that date (1995-2015) was only 4.67%. What did the S&P 500 return over that same period? It had an average annual return of 8.19%.
* As noted by Karl in the comments, a Vanguard study shows a smaller gap between investor and investment returns. Still a gap for sure, but perhaps a smaller one. Regardless, the behavior gap is costing investors a ton due to lost potential in wealth growth.
Let’s say you put $10,000 into your investment account and didn’t add to it again. Based on the average investor rate of return you would have almost $26,000 twenty years later. Not horrible. What if you had invested into an S&P 500 Index and never touched it over the same timeframe? Well, you’d almost double the investment account balance after 20 years!
Why is this? What causes investor returns to lag investment returns so badly?
1. Watching or reading investment news
Drama sells. It’s a sad fact. What if CNBC got on the air each day and said “Everything looks good in the stock market today. Remember, buy-and-hold wins the day.” Well, people would stop watching. To keep people watching newscasters report drama in the market. They spend time analyzing and recommending different investments. They go out of their way to convince you (and everyone else) that you can beat the market by listening to them and doing what they say.
Unfortunately, that just doesn’t hold up to scrutiny. It causes a lot of people to actively trade, and only a small percentage of active traders come out ahead.
2. Trading rather than investing
Studies show that people love to think they can time the market. They want to buy something at a great deal and sell it with a tremendous gain. Not even professional fund managers can do this consistently. In fact, less than 10% of professional fund managers beat the S&P 500 over the past 3-year period.
Every time you buy or sell an investment there is a cost. There is very often a cost to execute the trade. If there is a gain there is the cost of a tax liability. Costs always exist in some capacity but many investors don’t take time to consider the impact.
Making trades versus buying and holding onto investments can eat up a lot of profits over time.
Also, when investors are trading they tend to…
Portfolio income: Here’s why dividends are so important
How much money do you need to retire?
3. Buy investments at a high price
Every time there is a large run-up in the stock market the cash flows into the market jump way above average. One might even argue that part of the reason the market bubbles on occasion is this influx of buyers.
So what’s the problem?
Well, investors tend to jump in after most of the gains have already shown up in the market. Perhaps the stock market has been going great for a couple of years now so the investor decides they don’t want to miss any more gains and they buy-in – right near the peak.
Guess what happens after that?
4. Selling investments at a low price
After most investors have gotten off the sideline and put their money into the market, stock prices start to drop. Prices always drop. And that’s okay! Market cycles are normal and expected. There is a market correction (a drop of 10% or more) every 3-5 years on average.
Emotionally though it can “hurt.” Even knowing that markets “correct” every few years, when you see the value of your investment portfolio drop 10% or more, it can cause stress.
Most people are good for the first few percentage points of decrease. After a while though many can’t take it any longer and they decide to sell to avoid further “losses.”
What they don’t stop to consider is that you don’t lose anything unless you sell. So the loss they are trying to avoid actually gets locked in by selling! You know this. Everyone knows this. Still, it happens, and it happens all the time.
When the market goes back up, they jump back in. This winds up in a cycle of buying high and selling low – destroying a lot of investor equity.
What is the 4% rule and how can it help your financial planning?
5. Waiting on the sideline
Maybe you don’t trade. Maybe you don’t invest at all. Perhaps you have a list of reasons not to invest in the stock market.
Just put all your money in a savings account and everything will be fine, right? The problem there is that bank savings rates are HORRIBLE! Right now we’re excited to get 1.15% (at AllyBank) on our savings. That’s well below the target inflation rate, which means we’re essentially losing money by having it in savings. But, everyone should have some liquid money in savings for their emergency fund.
People talk and worry about the “risk” of investing in the stock market. More people need to take the time though to consider the risk of not owning stocks.
So what should you do?
Make a plan and stick to it! Figure out how much you can invest each month, and how you want it invested, and execute on that plan regardless of what the stock market is doing. This is called dollar cost average investing and it’s guaranteed to help you invest at lower-than-average share prices! If you want to understand how that happens, check out the post: Everyone Should Understand the Magic Math Behind Consistent Investing.
As a fee-only financial advisor, I can help you clarify your dreams and priorities, then develop an actionable plan to achieve your goals. Having a financial plan for your life includes much more than just investing, but intelligent investing is definitely part of the solution. Just select Start Here and let’s talk about how I can help you maximize your money to achieve the life of your dreams.
What do you think about this issue? Are any of these reasons a problem for you and your investments?
Individual investor under performance is an important issue, and I am glad you are covering it. Note that there may be some problems with the DALBAR study. The individual investor under performance gap definitely exists, but some people may be overstating the size of the gap. I talk about it here: http://www.mindfullyinvesting.com/update-to-article-4-1-on-fear-and-greed-problems-with-the-dalbar-studies/
Thanks for providing that additional information Karl. I’ll make a note on it.