When You are Making Investment Decisions, Leave Your Emotions at the Door
Causes of Poor Decision Making
These days, I find myself talking to clients quite a bit about the biggest risk to their portfolio: emotional decision making. During these conversations, I often refer to Dalbar’s Quantitative Analysis of Investor Behavior Study. The title speaks for itself because the report explains how the average investor can make unfavorable investment decisions over time. Take a look at the powerful data in the chart below and notice that over time the average investor underperformed the S&P 500 by 6.1 percent:
Source: J.P Morgan Asset Management; Dalbar Inc. Indexes used are as follows: REITS: NAREIT Equity REIT Index, EAFE: MSCI EAFE, Oil: WTI Index, Bonds: Barclays U.S. Aggregate Index, Homes: median sale price of existing single-famil homes, Gold: USD/troy oz, Inflation:CPI. 60/40: A balanced portfolio with 60% invested in S&P 500 Index and 40% invested in high-quality U.S. fixed income, represented by the Barclays U.S. Aggregate Index. The portfolio is rebalanced annually. Average asset allocation investor return is based on an analysis by Dalbar Inc., which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. Returns are annualized (and total return where applicable) and represent the 20-year period ending 12/31/15 to match Dalbar’s most recent analysis. Guide to the Markets – U.S. Data are as of September 30, 2016.
Indexes are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.
The Dalbar report not only illustrates investor performance, but it also takes the time to describe why the average investor underperforms the market. Their number one finding for underperformance is not fees or transaction costs, but the psychology of individuals. Dalbar goes even further to define and characterize the traits that lead to underperformance:
1. Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as “panic selling.”
2. Narrow Framing – Making decisions about one part of the portfolio without considering the effects of the total.
3. Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
4. Mental Accounting – Separating performance of investments mentally to justify success and failure.
5. Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
6. Herding– Following what everyone else is doing. Leads to “buy high/sell low.”
7. Regret – Not performing a necessary action due to the regret of a previous failure.
8. Media Response – The media has a bias toward optimism to sell products from advertisers and attract/view readership.
9. Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
Source: “Quantitative Analysis of Investor Behavior, 2016, “DALBAR, Inc. www.dalbar.com
Of the behaviors, Dalbar found “herding effect” and “loss aversion” to be the biggest problem for investors. It takes only one bad decision every three to four years to have a negative impact on the longevity of a portfolio. We believe it is exceptionally important for investors to realize that we all have these natural tendencies to be emotional about our decisions. The realization and acceptance of these behavioral tendencies are the first steps to moving past them.
One of the main reasons I am focused on having this discussion on behavioral investing today is because of where we sit in the current stage of this market. There has been quite a bit of volatility in the market in 2016. To be frank, we do expect to continue to have this roller coaster ride in the market despite the fact that we do not expect a recession in the near-term horizon. This is a change from what we saw out of the market in 2010-2014 as the S&P 500 averaged double-digit returns with unusually low volatility. In a period of higher volatility, it is important not to think too short-term about investments so as to ensure there is no overreaction when pullbacks occur. A better strategy is to consider the opportunities afforded to us on pullbacks and at what levels they become buying opportunities.
I recently wrote an article on the psychology of how financial stress may lead to actual physical pain. Click here to read the article.
Financial stress may lead to actual physical pain.
Nick Johnson, CFA®, CFP®
Nick Johnson believes that financial planning is more than numbers on a balance sheet and a standardized process. People are unique and should be treated as such.
As Vice President and a Wealth Manager at Willis Johnson & Associates, his goal is to really get to know his clients, all the while providing a proactive approach to comprehensive wealth management.