The Behavior Gap
“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
– Benjamin Graham, author of The Intelligent Investor
Research on investor behavior again confirms that most of us aren’t wired to make good investment decisions – especially when those decisions are made in response to the kind of extreme volatility seen in equities markets since 2008. In 2010, the S&P 500 Index returned 15.1%, while the return for the average equity fund investor came in at 13.6%, underperforming the S&P 500 by nearly one and one half percent. Even more compelling, from January 1991 through December 2010, the average equity fund investor earned an annual return of only 3.8%, underperforming the S&P 500 by an astonishing 5.3% per year.
Why have equity fund investors’ results lagged so far behind the S&P 500, a widely-followed equities index? While the high costs associated with many retail funds contributed to the gap, the primary reason is that investors exhibited behaviors they would have been better off avoiding: timing the market and not holding funds long enough. Hence the term “behavior gap.”
When the going gets tough, investors panic
When investors move money in and out of investments in hopes of riding the tide of a rising market and then jumping ship just before a downturn, they’re timing the market. Generally, it’s a risky guessing game that investors should not play with their hard-earned money.
DALBAR, Inc., a Boston-based company that provides research for the financial services industry, examined mutual fund investors’ results in equities markets during the 20-year period that ended December 31, 2010. DALBAR found that investors made money in 14 of those years. During the six money-losing years, there were steep declines in equities markets, and when investors panicked and made bad market-timing decisions, they ended up buying high and selling low and intensifying their losses.
All-too-brief holding periods
Talk to any investor and you may well find that his or her equity fund investments have not been able to achieve the level of long-term results touted by the fund companies. Fund companies tend to market their products using the long-term results that would have been achieved by someone investing a lump sum in fund shares at the start of the measurement period and then holding them the entire period. When investors vary from such a buy-and-hold strategy, their own long-term results may well fail to live up to what was advertised.
According to DALBAR, investors typically hold equities for less than four years on average – not long enough, given that equities should be used primarily to achieve growth for long-term goals. DALBAR advises that investors will be better able to achieve long-term returns comparable to those reflected in marketing materials when they invest systematically – thus taking advantage of dollar-cost-averaging – and follow a buy-and-hold strategy.
An investor’s holding period helps determine the results he or she achieves on that investment. In fact, any decisions a person makes as an investor – including decisions about whether or when to buy or sell or switch into and out of funds – will have a significant impact on his or her results. Investment return is far more dependent on investor behavior than on fund performance.
At Grand Wealth Management, we help our clients rein in emotions that may lead to poor investment decisions. With our guidance, clients are able to follow a rationally thought-out, structured and disciplined investment strategy based on their personal circumstances and goals.
Learn more about DALBAR’s Quantitative Analysis of Investor Behavior by reading the extract, available from Grand Wealth Management here.