Where Do We Start the Journey?

| January 05, 2015
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Peaceful Wealth

Why do we make such bad investment choices? Is it inferior investment products, bad investor behavior or a flawed investment marketplace that leads to bad investment decisions?"

These are the fundamental questions I ask myself every time I review studies from the research firm DALBAR, Inc. (www.dalbar.com) identifying the massive gulf between the benchmark returns of the stock market and the real returns achieved by the average investor. In an era of instant information, powerful computers, sophisticated markets and thousands of firms claiming to educate and enrich their clients we should see and hear only glowing testimonials from wealthy and happy investors. A sense of Peaceful Wealth should define every investor’s personal journey. Or so it would seem.

Unfortunately, the average investor is drowning in a sea of failed investments. Wealth, let alone Peaceful Wealth, continually feels just outside our grasp. Today’s new tools, new systems and new products offer scant protection from the deep. For the past 20 years DALBAR, Inc. has been investigating and reporting the returns investors actually realize in their pursuit of personal profit. The 2014 edition of DALBAR’s Quantitative Analysis of Investor Behavior (QIAB 2014) study looked at the thirty-year period from 1984 to 2013 and found the average equity investor made only 3.69% per year even though the S&P 500 was up 11.11% per year for the same period. Underperforming the market by 7.42% per year is horrendous, especially when individuals and families must increasingly rely on their investments to fund retirement.

In the words of Pogo the Possum, "We have met the enemy and he is us."

I have been a huge fan of DALBAR since the first time I encountered their studies in 2007. Their findings and their analysis has remained clear and consistent, the "fix" for the atrocious performance of most investors is to simply make better choices and eliminate bad behaviors. To quote that initial QAIB 2007 study I read, "Whether the mutual fund industry is enjoying rapid expansion in times of economic boom, or is being battered by the bears, the key findings uncovered in DALBAR’s first study from 1994 remain true: Investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who hold their investments are more successful than those that time the market."

The report continued, "QAIB applies the principles of behavioral finance to provide

measurements and insights into what mutual fund investors really do, what is in their best interest and what it costs them. Central to improving investor behavior is correcting the irrational actions that are driven by the behavioral finance factors of:
Loss aversion... expecting to find high returns with low risk. Narrow framing... making decisions without considering all implications. Anchoring... relating to the familiar experiences, even when inappropriate. Mental accounting... taking undue risk in one area and avoiding rational risk in others. (Improper) Diversification... seeking to reduce risk, but simply using different sources. Herding... copying the behavior of others even in the face of unfavorable outcomes. Regret... treating errors of commission more seriously than errors of omission. Media response... tendency to react to news without reasonable examination. Optimism... belief that good things happen to me and bad things happen to others."

It is hard to refute DALBAR’s central thesis. Bad behavior leads to poor returns because poor returns occur when investors make irrational choices. Investment returns will soar as soon as we avoid irrational behavior and eliminate bad choices. Discipline, consistency and perspective are the three-legged stool upon which every successful investor is perched. The road to Peaceful Wealth starts by recognizing and eliminating the behaviors that can sabotage our best efforts and the preconceptions that will rob us of our goals. We can be our own worst enemy along our journey.

"Good pitching will stop good hitting and vice-versa." - Casey Stengel

Investors commonly brand any strategy a success simply because it worked well once. Knowing we have limitations does not immediately allow us to overcome them. The sentiments of baseball manager Casey Stengel are repeated daily as we seek to justify why an investment succeeded or failed. Discipline, consistency and perspective are ideal guides every investor ignores at their own peril.

But this is only the beginning of our journey, not the destination. DALBAR implies the only (or at least the fundamental) problems investors face are behavioral. Should we embrace the notion every investment strategy and each mutual fund will eventually work to our advantage if we simply wait long enough? Does every failure imply the decision was flawed? Who decides what choices are irrational and which behaviors are bad? How are we to sort through all the gurus, newsletters, trading methods and software programs that shout-out a message of special market knowledge and unique timing signals? What role does the typical broker or advisor play in creating Peaceful Wealth? Good questions all. We’ll dig even deeper next time.

 

This material is intended for educational purposes only and is not intended to serve as the basis for any investment or purchasing decisions.

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