Market Performance and Investor Performance
Finance

The Disconnect Between Market Performance and Investor Performance

A recent study found that the average investor earned 3.7% annually over the past 30 years – a period in which the S&P 500 stock index returned just over 11% annually. That means investors underperformed the market by about 7% annually for three decades, according to Dalbar, a financial-research firm in Boston that has updated this study every year since 1994[1].

I find that to be an amazing statistic. It’s a sad statistic at the same time. How is that even possible? One reason could be that life just gets in the way. Many pull money out of their investmentsto make a down payment on a house, to make a tuition payment, to take a vacationor to fund a retirement.

However, the primary determinant of long-term, real-life investment outcomes isn’t investment performance; it’s investor behavior. Having a trusted financial advisor that can help guide you when it comes to investor behavior can make a world of difference in the long run.

Investors are susceptible to a litany of behavioral mistakes that can make all the difference between what kind of investment performance they receive compared to what kind of performance their investments average over time.

Market Performance and Investor Performance

Avoiding the following eight behavioral mistakes can potentially help close the gap between market performance and investor performance.

  1. UNDER DIVERSIFICATION –This is a huge one and it can be serious. It is essentially the narrowing down of a portfolio to one idea. An example would be the loyal employee who owns too much company stock in their 401k or the person who loaded up on tech stocks back in 2000. Holding the preponderance (much less, heaven forbid, the totality) of your equity “portfolio” in one stock or sector isn’t investing. It’s roulette.
  2. OVER DIVERSIFICATION –This one is not as common as the others, but it can still be a problem. Imagine the person who is always chasing what’s hot and ends up with 25 different investments in his portfolio. He’s left with a hodgepodge of investments with redundancies and fee inefficiencies. The overdiversified investor, in the act of owning too much, ends up receiving too little in returns.
  1. GREED – When consumed by greed, people no longer have a sense of fear. The possibility of losing principal is no longer considered. The only concern is that someone somewhere is making more money than you are. Greed leads to very poor decision making.
  1. PANIC –Panic is nothing more than a loss of faith in the future. The world does not end; it only appears to be ending at times. In the past, all market declines have been temporary. This time is likely no different.
  1. LEVERAGE – Leverage can be a dangerous tool. Borrowing at the wrong times and on the wrong terms, in order to buy the wrong things at the wrong times for all the wrong reasons can be extremely harmful to a portfolio and possibly even lead to margin calls.
  1. SPECULATION – I don’t have a problem with someone speculating with a portion of their capital. But I don’t believe that you should ever speculate with any part of the core portfolio that you have committed to the pursuit of your life goals. The ability to distinguish between investment and speculation becomes critical to financial success. Examples of speculative investments might be investing in penny stocks, stocks without positive earnings, or some alternative investments.
  1. INVESTING FOR CURRENT YIELD INSTEAD OF FOR TOTAL RETURN –This is typically the classic mistake of the retiree. The simple truth is that investments which have the highest current yield have the lowest total return, while investments with lower current yield typically compensate by offering a higher long-term total return. Since retirees’ income must generally last through approximately three decades of retirement and continually rise to offset the constantly rising cost of living, they need to focus not on today’s yield but on long-term total return. The total return of equities has been, over the long run, upwards of twice that of bonds (as measured by S&P 500 performance compared to the Barclays Aggregate Bond Index)[2]. While past performance is not a guarantee of future results, this shows that equities have been a much more reliable source of growth – one that historically far exceeds increases in the cost of living.
  1. LETTING YOUR COST BASIS DICTATE YOUR INVESTMENT DECISIONS – People just naturally get emotionally tied up into the price they paid for their investments. But your cost in an investment has nothing to do with its objective value today. Indeed, your investments do not know what you paid for them, and would not perform any differently if they did. This mistake often shows up in one of two ways. The first is the refusal to migrate back toward proper diversification because one very successful investment would generate substantial capital gains taxes were it sold. The second is the person who just refuses to sell something that should be sold simply because it is worth less than what she paid for it. The price paid for an investment should generally never become the reason for holding it.

Avoid these behavioral investment mistakes and potentially improve your investment performance. Bedford Federal Wealth Management has a team of financial advisors and wealth advisors that can help you avoid those behavioral investment mistakes and then help you develop a plan for your financial future.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

[1] DALBAR’s 2014 Quantitative Analysis of Investor Behavior (QAIB) study examines real investor returns from equity, fixed income and money market mutual funds from January 1984 through December 2014. The study was originally conducted by DALBAR, Inc. in 1994 and was the first to investigate how mutual fund investors’ behavior affects the returns they actually earn. Past performance is no guarantee of future results. Indexes cannot be invested into directly.

[1] The S&P 500 Index is an index of 500 chosen stocks chosen for market size, liquidity and industry grouping, among other factors. It is designed to be a leading indicator of U.S. equities. The Barclays Aggregate Bond Index is a broad base index maintained by Barclays Capital and is often used to represent investment grade bonds.

Author: Michael Bellush, Financial Advisor