Bridging the investor behaviour gap

Why being the “average investor” can be detrimental to your wealth.

Summary: A study of US investment returns over the 20 years to December 2011 has found that while the S&P 500 index returned 7.81% over that time, the average investor only achieved 3.49%. Why? Put it down to human behaviour.
Key take-out: Long-term investors who hold on to their investments have been generally more successful than those who try to time the market.
Key beneficiaries: General investors. Category: Investment strategy.

Every year the US-based research firm Dalbar does a study that tries to quantify the impact of investor behaviour on real-life returns by comparing investors’ earnings to the average investment (using the S&P 500 as a proxy).

The study utilises the net of aggregate managed fund sales, redemptions and exchanges each month as a measure of investor behaviour. This method of calculation captures realised and unrealised capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs. These behaviours are then used to simulate the “average investor”. Based on this behaviour, the analysis calculates the “average investor return” on an annualised basis.

This chart below illustrates an “average investor” as an investor who is in an “asset allocation portfolio” of both equities and bonds. The latest study looks at the 20-year period that ended December 31, 2011. The results showed that between December 1992 and December 2011, the S&P 500 returned 7.81% per annum. The average investor over the same period, however, achieved a return of only 3.49% p.a.

The 4.3% left on the table, “The Behaviour Gap”, is largely the result of the emotionally driven investment decisions made by investors. Whilst there are arguments that timing of available cash flows also have an impact on investor decisions and may count for part of this gap, the results do provide evidence of the impact of investor behaviour on investment portfolio performance.

If you had put money into an S&P 500 index fund 20 years ago and just left it there – no buying, no selling, just investing and forgetting about it – you would have earned (minus fees) about 7.5%.

But many people don’t invest that way. They trade. They read the doom and gloom often reflected throughout the financial media, listen to their broker spruiking the next best thing, and now and then take a punt on the advice of their mates from the BBQ the night before.

Despite knowing better, we give into the genetic tendency to get more of those things that give us pleasure – buy high – and get rid of things that cause us pain – sell low.

The principles of behavioural finance help explain why investors often make buy and sell decisions that contradict best investment practice. In order to correct the behaviour, investors need to understand and acknowledge that they suffer from some of the following most common behaviours:

Loss aversion

People are more sensitive to the possibility of making a loss than of earning a gain. We make bold forecasts, but timid choices. We expect high returns but low risk. What’s important is to embrace your long-term objectives, understand what it means to fall short of your goal and in turn fear THAT loss.

Recency bias

We are all prone to recency bias, meaning that we are overly influenced by events in the recent past and tend to extrapolate them into the future indefinitely. In doing so, investors are assuming that what has occurred in the recent past will continue to occur indefinitely. At the same time, investors are also assuming that if something hasn’t occurred in the recent past, it won’t happen in the future.

On the back of recent higher returns in equity markets investors will question whether markets can keep going and the likely outcomes for 2014. Recency bias may well see investors taking money off the table at the wrong time in the expectation markets will again suffer a fall as occurred following the strong growth in equity markets leading up to the highs prior to the GFC in 2008.

Of all the cognitive biases that influence human behaviour, recency bias is by far the most harmful to long-term investors and leads to investors falling into the trap of buying high and selling low. The point isn’t that you should have predicted the timing of the bubble or an upswing but that you should have considered both possibilities as potential outcomes and planned accordingly.


The concept of anchoring draws on the tendency to attach or “anchor” our thoughts to a reference point – even though it may have no logical relevance to the decision at hand.

For example, some investors invest in the stocks of companies that have fallen considerably in a very short amount of time. In this case, the investor is anchoring on a recent “high” that the stock has achieved and consequently believes that the drop in price provides an opportunity to buy the stock at a discount. It is true that the fickleness of the overall market can cause some stocks to drop substantially in value, allowing investors to take advantage of this short-term volatility.

However, stocks quite often also decline in value due to changes in their underlying fundamentals.

For instance, suppose that XYZ stock had very strong revenue in the last year, causing its share price to shoot up from $25 to $80. Unfortunately, one of the company’s major customers, who contributed to 50% of XYZ’s revenue, had decided not to renew its purchasing agreement with XYZ. This change of events causes a drop in XYZ’s share price from $80 to $40. Keep in mind that XYZ is not being sold at a discount, instead the drop in share value is attributed to a change to XYZ’s fundamentals (loss of revenue from a big customer).

When it comes to avoiding anchoring, there’s no substitute for rigorous critical thinking. Be especially careful about which figures you use to evaluate a stock’s potential. Successful investors don’t just base their decisions on one or two benchmarks, they evaluate each company from a variety of perspectives in order to derive the truest picture of the investment landscape.

Following the herd

As we are all social beings, our behaviour can be highly influenced by others. This can create herding and a tendency to follow fads. Copying the behaviour of others even in the face of unfavourable outcomes. CDOs became a global trend during the early 2000’s. By 2009 they were highlighted as the root cause of the GFC.

Perhaps the biggest example of herding was the dotcom/tech bubble of the late 1990’s. Investors were frantically investing huge amounts of money into internet-related companies, even though most of these dotcoms did not (at the time) have financially sound business models. The driving force that seemed to compel these investors to sink their money into such an uncertain venture was the reassurance they got from seeing so many others do the same.

Just remember that particular investments favoured by the herd can easily become overvalued because the investment’s high values are usually based on optimism and momentum and not on the underlying fundamentals. The soundest strategy is always to “do your homework” before following any trend.

Familiarity bias

Investors tend to bias their portfolios to markets, companies and sectors that are close to home and with which they are familiar. Australians have an affinity with our own high franked dividend stockmarket. With the ASX representing only 3.8% of the world markets, overweighting portfolios towards a “home bias” reduces diversification and excludes investors from wider opportunities.

At the time of writing (December 16, 2013) the rolling 12 month return for the S&P/ASX200 has been 26.4% as against the S&P500 at 31.7%. Indeed the S&P500 is back to its historical highs post GFC, whereas the ASX200 is still 22% off its pre-GFC high of 6851. Investors who have ignored an allocation to International Equities most certainly will have underperformed in recent times.

So what do we do about it?

1. Admit it. Like any destructive behaviour the first step to fixing it is to admit that there is a problem in the first place. Being honest with yourself and reviewing past decisions will help:

  • Did you get caught up in the tech bubble in 1999?
  • Did you sell down in 2002, or early 2008?

2. Develop a sound investment policy and strategy. Then employ a disciplined approach to applying that strategy. Ensure you assess any investment decision in light of your overall strategy before you make any major decisions.

“To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insight, or inside information. What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding that framework.” Preface by Warren Buffett in “Intelligent Investor” by Benjamin Graham

The bottom line

Long-term investment results are heavily dependent on investor behaviour. Strong asset selection has shown to be typically beneficial. However, long-term investors who hold on to their investments have been generally more successful than those who try to time the market.

The reality is, investing successfully is hard. But hopefully by focusing on our behaviour, we can close this gap in the next 20 years.

This is an article written by Roger Wilson, Partner at Lachlan Partners and first appeared in “The Investing Times” newsletter.

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