The average equity fund investor regularly buys high and sells low while owning a given investment for just over three years.*
From time to time, every investor makes decisions they regret. Have you ever wondered what those mistakes cost you? Some years ago, a research company called Dalbar decided to find out. They began gathering data on investor activity in order to help us understand the financial impact of our decision-making activity.
Generally, what guides us in our decision-making? Stock phrases in the investment world strongly point us in a certain direction: “Buy low, sell high.” or “I'm only looking for a double or triple.” or “Only buy the winners!” Subliminal direction like this begins to occupy our minds and affect the kinds of decisions we make. Judged against short-term outcomes—on a day-to-day, week-to-week or even year-by-year basis—it is difficult to measure the effect of our decisions. To really understand the impact of our decision-making over the long-term, we need meaningful and effective measurements that are tracked over a much longer period of time.
That’s why Dalbar's Quantitative Analysis of Investor Behaviour study* is of such interest to anyone who wants to have a better investing experience. Since 1994, Dalbar has been measuring the effects of investor decisions to buy, sell, and switch into and out of mutual funds over both short- and long-term time frames. What the results consistently show is that the average investor earns less—in many cases, much less—than mutual fund performance reports would suggest.
When we compare time weighted index returns to dollar weighted mutual fund returns, we recognize that the average equity fund investor regularly buys high and sells low while owning a given investment for just over three years. So much for the effectiveness of the subliminal direction to buy low and sell high! What is the actual cost of this investment pattern of buying high, selling low and moving from fund to fund? As shown in the graph below, over 5% in average returns per year is given up to bad decision-making.
You are justified in wondering why this pattern continues if we have been able to measure the detrimental effects on investment portfolios since 1994. To find out, pick up your daily newspaper and read the daily business news report, or listen to your friends and colleagues talking about their latest hot investment tips. Although an effective investment plan should act as a roadmap that allows for periodic detours en route to a long term goal, in practice, people often view investing as a game to be won or lost on short-term decisions. Research shows that when the market is advancing, investor money goes in; and when the market is declining, investor money exits or sits on the sidelines.
Over the long term, the market proves to be smarter at sorting out the wheat from the chaff than any of us as individuals. Even though stocks tend to wander around somewhat randomly in the short-term, changing directions multiple times during any average trading day, it’s important to recognize that the reasons for these short-term directional shifts are unimportant. The key thing to keep in mind is that, over the long term, investors are rewarded for capital placed at risk in the markets. Once we internalize this reality, we can discipline our behaviour to achieve the returns of the markets and avoid the fate illustrated above of the average investor.
Invest smart and let the markets work for you—not against you!
*Dalbar Inc. QUIB March 2011
This article by Daryn Form was published in the March 2012 edition of Sask Business Magazine.