10 Behaviors that Lead to Underperformance

August 4, 2016 | by James Behr Jr & Christopher Paleologus

“In 2015, the average equity mutual fund investor underperformed the S&P 500 by a margin of 3.66%. While the broader market made incremental gains of 1.38%, the average equity investor suffered a more-than-incremental loss of -2.28%” –Dalbar’s 22nd Annual Quantitative Analysis of Investor Behavior. This is not a one year aberration but a long term trend. The long term track record is even worse according to Dalbar, “The 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.” If you were to start with $100,000 and make no additions, after 20 years the S&P balance would be $482,772.38 whereas the average mutual fund investor would have only grown to $249,140.59 a difference of $233,631.79.

This underperformance is caused by a variety of factors including poor timing, psychological traps, and misconceptions. Below we will discuss 10 investor behaviors that lead to poor investment results.

Loss Aversion – Investors typically feel the pain of financial loss much more intensely than the pleasure felt from financial gain of the same size.

     – Example: Consider a situation where you could either accept $500 or face 50-50 odds of winning $1000 or nothing at all. Most people would take the $500 — a sure thing. If you then ask those same people whether they’d rather lose $500 or face 50-50 odds of losing $1000 or nothing, they would choose the coin toss. Investors are willing to assume a higher level of risk in order to avoid the negative feeling associated with a prospective loss.

Narrow Framing – When an investment decision is made without considering all of the factors that may affect the investment.

      Example: An investor may buy a security because of its past performance without considering that their portfolio is already overweight in that stock’s particular sector.

Herding – The tendency for an investor to follow the actions of the larger group.

       – Example: The dot-com bust in the stock market was caused by many investors piling large amounts of money into internet related companies even though they were uncertain ventures because of the social pressure of conformity and the common rationale that it’s unlikely that such a large group could be wrong. It is also our experience that commissioned based brokers contribute to this mistake because they are constantly selling what is popular as it is the easiest to sell.

Regret – Deals with the emotional reaction people experience after an act or failure to act on an investment decision.

       – Example: An investor purchases a stock and it immediately goes down. Rather than selling out of the position and holding cash or reinvesting in another company, they decide to hold onto the position and continue losing money for fear of feeling bad about taking the loss.

Mental accounting –The idea that investors compartmentalize their money which affects how a person will spend money differently depending on the compartment it fits in.

        Example: Tax refunds. Tax refunds are often viewed as “found money” when received, often used for vacations or large purchases, even though it is earned income that was received throughout the year and should be treated the same way.

Anchoring – When investors base investment decisions on immaterial figures, statistics, or prices.

        Example: An investor buys a stock at $50 due to its performance over the past year. It then falls to $25 as a result of its top customer deciding to work with someone else. The investor refuses to sell the stock until it goes back to at least $50 because that is where they purchased it and are anchored.

Overconfidence – Overestimating or exaggerating one’s ability to successfully perform a particular task.

       – Example: An investor has some success trading stocks to earn profits and begins to think that every trade they make will lead to more profits which leads to more trading and more risk.

Confirmation Bias – The idea that people tend to gather information that confirms their existing opinion and ignore information that differs with their beliefs.

       – Example: An investor hears about a “must own stock” and proceeds with their due diligence. Often times while researching, investors will only look at information that supports their initial theory that it is a good buy while avoiding research that states otherwise.

Diversification – The only thing most investors know about diversification is not to put too many eggs in one basket. Investors may own too many stocks or too few stocks. Their portfolios may consist of many different companies but they are all in the same sector that can be vulnerable to many of the same economic factors. Moreover, they may own many different equity or bond mutual funds who all own many of the same stocks or bonds.

        Example: In order to diversify their portfolio an investor creates a new position in ExxonMobil even though they already own Chevron, a company that is in the same industry and vulnerable to similar risks.

Active Trading – Trading too frequently. With more technology people are now able to trade very cheaply from just about anywhere. Overconfident investors now have more information and easy to use tools making it simple to try and make the quick big buck. This usually results in undo risk, loss of capital, and large trading fees.

        Example: An investor trades in his portfolio throughout the year, always buying and selling positions. By the end of the year, the market is positive but they haven’t made any money and actually lost money due to excess trading fees.

 


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