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Why Do Investors Really Underperform Over Time?

October 8, 2014

by Lance Roberts

of Streettalk Live

There have been numerous articles written as of late that have chastised individuals for"missing out on the bull market" which was only slightly worse than "not beating it." The reasons were chalked up to bad investment advice and paying "too much" in fees which caused the underperformance. While both of those reasons may be contributors to the problem, they are in reality on very small components of the problem when compared to the three single largest contributors to investor underperformance over time.

I am currently preparing a speech for the 2014 Houston CPA Society Personal Financial Planning Conference where I am going to discuss the changing world of investment management and portfolio theory. As part of that discussion, I will address the three biggest reasons why individuals fail to achieve the investment returns touted by Wall Street media. How big is this underperformance? According to the 2014 Dalbar Investor Behavior Study, it is quite substantial.

Investor-Performance-vs-SP500-100714

Accordingly to the Dalbar study, the three primary causes for the chronic shortfall for both equity and fixed income investors is shown in the chart below.

Reasons-Investors-Fail-100714

Notice that "fees" are not an issue. The real problem for individuals comes down to just two primary issues: a lack of capital to invest and psychology.

I will not deny that "costs" are an important consideration when choosing between two specific investment options; however, the emotional mistakes made by investors over time are much more important.  Let's examine each of these issues.

Lack Of Capital

Over the last couple of years in particular, the investing public has been consistently bashed by the mainstream media and analysts for "missing the rally."  Of course, it would be helpful if Wall Street had not been telling individuals to stay invested during the last two bear market corrections that wiped out a tremendous amount of investible wealth. 

In order for individuals to invest, they must have discretionary "savings" with which to invest with. Unfortunately, between weak economic growth, stagnant incomes, rising costs of living and two major "bear" markets; nearly 80% of Americans simply are not able to participate.  This point was clearly made by the recent Fed study on consumer finances which showed that for the majority of American's there has been no recovery. To wit:

"Another mainstream media theme has been that the surging stock market, driven by the Federal Reserve's monetary interventions, has provided a boost to the overall economy. However, as I have suggested previously, the bulk of the population either does not, or only marginally, participates in the financial markets. Therefore, the 'boost' has remained concentrated in the upper 10%. The Federal Reserve study breaks the data down in several ways, but the story remains the same.The median value of financial assets for families has fallen sharply since the turn of the century."

Fed-Survey-2013-Assets-091014

The story is even more understandable when you look at the "baby boomer" generationwho have been the primary participants in the financial markets over the last 20 years.

"Recent statistics show that the average American is woefully unprepared for retirement. On average, 40% of American families are NOT saving for retirement, and of those who are, it is primarily about one year's worth of income.  Furthermore, important to this particular conversation, one-fourth of those at retirement age postponed retirement with only 18% being confident of having enough saved for retirement."

American-Family-Financial Statistics-051414

Notice the AVERAGE savings account balance is $3800. Since we know that the top 10% of American's have the bulk of the wealth in the U.S., in order to get an average balance of $3800 means that there are a LOT of families with no savings balance at all. It is not surprising that 24% of "baby boomers" are postponing retirement due to an inability to do so financially. Of course, this explains why the employment level of individuals OVER the age of 65, as a percent of the working age population 16 and over, has risen sharply in recent years. 

Employment-65-Over-051414

The "lack of capital" to invest is critical in the understanding of why the Federal Reserve's ongoing monetary interventions have had such an anemic effect on the overall economy. The Federal Reserve had hoped that by inflating asset prices, the corresponding "wealth effect" would boost consumer confidence and encourage higher levels of consumption. What the Fed did not realize is that a vast majority of American households could only watch from the sidelines.

Psychology

While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology. 

Behavioral biases that lead to poor investment decision making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:

  • Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time.  Also known as "panic selling." 
  • Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total. 
  • Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
  • Mental Accounting – Separating performance of investments mentally to justify success and failure.
  • Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
  • Herding– Following what everyone else is doing. Leads to "buy high/sell low."
  • Regret – Not performing a necessary action due to the regret of a previous failure.
  • Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
  • Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.

The biggest of these problems for individuals is the "herding effect" and "loss aversion."

These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of "holdouts" finally "buys in" as the financial markets evolve into a "euphoric state."

As the markets decline, there is a slow realization that "this decline" is something more than a "buy the dip" opportunity.  As losses mount, the anxiety of loss begins to mount until individuals seek to "avert further loss" by selling. As shown in the chart below, this behavioral trend runs counter-intuitive to the "buy low/sell high" investment rule.

Investor-Psychology-Cycle-062414

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

More importantly, despite studies that show that "buy and hold," and "passive indexing"strategies, do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits. But then again, since the majority of American's have little or no money with which to invest, maybe a bigger problem is the lack of financial education to begin with.

Lance Roberts

Lance Roberts is the General Partner and Chief Portfolio Strategist for STA Wealth Management. He is also the host of “The Lance Roberts Show,��?Chief editor of the X-Factor Investment Newsletter and the Streettalklive daily blog. 
 

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