By SJS Investment Services Investment Associate Bobby Adusumilli, CFA.
Over the past 40 years, advances in investment offerings and technology have provided investors with far more opportunities to invest in stocks and bonds compared to the past. From their laptops, people can now invest in markets all around the world. Mutual fund and ETF expense ratios have been decreasing, with many index mutual funds and ETFs approaching a 0.00% expense ratio.[1] Congress has created tax-advantaged accounts such as IRAs, 401(k)s, 529 plans, and HSAs to encourage people to invest while saving on taxes over time.[2] And more recently, many brokerage firms no longer charge trading commissions on stock and bond trades.[3]
Given all of these advances, you would think that investors have gotten better at earning their fair share of investment returns. However, you may be surprised to learn that most stock and bond investors in the US still significantly underperform the market averages.
For example, as of 31-Dec-2019, DALBAR found that the average equity mutual fund investor underperformed the S&P 500 (a benchmark for the US stock market) by nearly 5% annually over a 30-year span.[8] For a $100,000 initial investment, that’s a 30-year ending portfolio balance of $437,161 for the average equity mutual fund investor compared to $1,726,004 for the S&P 500.[4]
What explains this underperformance? We think that part of the explanation is that many investors trade too much, as well as pay too much in transaction fees (including bid-ask spreads), high expense ratios, and unnecessary taxes. However, we think a bigger part of the explanation relates to investor psychology. In particular, we want to emphasize six aspects of investor psychology - also known as cognitive biases - that tend to hurt investor performance, and what investors can do to address these biases.[5]
Overconfidence
Overestimating our skills or circumstances, which interferes with our ability to make good decisions. For example, when evaluating a particular investment, an investor may feel really confident that they have a much better analysis than the general market.
Loss Aversion
The tendency to be driven more strongly to avoid losses than to achieve gains. For example, even when presented with better investment opportunities, an investor may decide to keep holding a stock that has declined in value until it can be sold at a gain.
Confirmation Bias
The tendency to seek out and interpret information that confirms or strengthens our existing beliefs. For example, after making an investment in a particular stock, an investor may actively search for news and analyses that support the decision to invest, as opposed to considering other news or alternative analyses.
Recency Bias
Believing that recent events are more likely to occur than they actually are. For example, a year after a major stock market downturn, many investors still avoid investing because they believe that another major downturn is likely to happen in the short-term.
Endowment Effect
The tendency to place more value on an investment that you own compared to the price it can be purchased / sold at on the open market. For example, particularly for an inherited stock or stock in the family business, an investor may value their shares more than the current market price.
Optimism Bias
The belief that our chances of experiencing negative events are lower and our chances of experiencing positive events are higher than the averages. For example, many investors believe that if they just have good returns over the short-term, they will be much happier and better off in the future.
What Can You Do About Your Cognitive Biases?
Cognitive biases are easy to write about, but hard to actually prevent from negatively impacting our investment returns. Based on our years working with clients, we find that the below actions tend to help investors achieve better investment returns:
Define Your Circle Of Competence, And Don’t Stray Beyond That
There are many different investment styles that have helped people become wealthy over time. However, because there are so many investors competing to find the best investments, many top investors only focus on one particular style of investing that they understand really well, and don’t even consider other potential investments. This frees them to focus on what they do best, and ignore everything else.
Create Strategies And Systems That Do The Work For You
Instead of making a new decision each time you have money to invest (which is often stressful and time-consuming), you can instead create a strategy and system that automatically makes the decision for you. For example, many of our clients benefit from the below investment process:
Invest in broadly-diversified, low-cost, tax-efficient global mutual funds and ETFs.
Maximize contributions to tax-advantaged accounts, such as IRAs, 401(k)s, and HSAs.
Dollar-cost average: every time you have money to invest, immediately invest according to your pre-specified asset allocation.
Have a pre-specified and largely automated rebalancing strategy.
Cap Your Downside Risks
As investor Warren Buffett says about investing: “Rule Number 1: Never lose money. Rule Number 2: Don’t forget Rule Number 1.“ When deviating from a well-crafted and implemented investment strategy, much more can go wrong than can go right. We generally advise for investors to limit all of their niche investments to less than 10% of their overall portfolio. Additionally, we encourage investors to have an emergency fund with six months' worth of expenses, as well as all appropriate insurance coverage, in order to protect themselves in case something happens to them or their investments.
Respect The Averages, And Only Deviate From Your Plan If You Actually Have An Advantage
Many studies have found that investors who buy and hold broadly-diversified, low-cost, global index mutual funds and ETFs outperform the vast majority of investors over the long-term.[6] Investing in stocks and bonds is extremely competitive. As a result, if you don’t have a particular competitive advantage, or if you are not able to spend the necessary hours to do thorough research on a regular basis, then you probably won’t benefit from attempting to time the market or investing in niche investments.
More Money Probably Won’t Make You Much Happier
Through his research, Nobel-Prize-winning psychologist Daniel Kahneman has found that while being poor makes people miserable, for most people with a basic level of wealth, more wealth does not significantly increase day-to-day well-being.[7] Once an investor has a good investment strategy in place and reviews this strategy periodically, spending more time analyzing investments is unlikely to significantly improve investment returns or make someone happier over time.[4][6][7]
Summary
As the data shows for the majority of people, investing well over the long-term is tough.[4][6] By understanding ourselves better and creating well-thought-out & systematic investment processes, we think that investors are more likely to earn their fair share of investment returns over time.
Important Disclosure Information & Sources:
[1] “Pay Attention to Your Fund’s Expense Ratio“. Jean Folger, 27-Oct-2020, investopedia.com.
[2] “The Basics of a 401(k) Retirement Plan“. Mark Cussen, 29-Mar-2021, investopedia.com.
[3] “In the race to zero-fee broker commissions, here’s who the big winner is“. James Royal, 04-Oct-2019, bankrate.com.
[4] “2020 QAIB Report”. DALBAR, 2020, wealthwatchadvisors.com.
[5] How to Decide. Annie Duke, 2020, Portfolio / Penguin.
[6] Unconventional Success: A Fundamental Approach to Personal Investment. David Swensen, 2005, Free Press.
[7] Thinking, Fast and Slow. Daniel Kahneman, 2013, Farrar, Straus and Giroux.
There is no guarantee investment strategies will be successful. Past performance is no guarantee of future results. Diversification neither assures a profit nor guarantees against a loss in a declining market.
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The S&P 500 Index is a free float-adjusted market-capitalization-weighted index of 500 of the largest publicly traded companies in the United States.
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