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So You Think You Can Outperform The Market? Well, Think Again.


When you think of investing in the market, the image you most likely conjure up is one of a lavish individual consistently picking companies that outperform all the rest and leading a life of wealth and luxury. However, this is most definitely not the norm. Dalbar, a research company which performs quantitative analyses of investor behavior, consistently showcases that market outperformance is highly unlikely in each of its past 20 annual research studies. Let’s take a look at the most recent data to support this dismal truth.

During the 2015 fiscal year, investors consistently underperformed the market and experienced diminished returns compared to the S&P 500. While you may maintain hope that you will defy this statistic, it was shown that the average equity mutual fund investors underperformed the S&P 500 by 3.66% annually and suffered a more-than-incremental loss of 2.28%, illustrating that you are more likely than not to underperform and suffer losses. Furthermore, average fixed income mutual fund investors also fell 3.66% short of the Barclays Aggregate Bond Index with a loss of 3.11%, proving that even investing in mutual funds is likely to underperform.

While these figures show strong underperformance, a particularly striking insight is that investor behavior is the number one contributor of investor underperformance, while fund and trading fees are the second leading cause, demonstrating that you are your own worst enemy when it comes to investments. Overall, this data displays how at face value, the odds of an individual investor outperforming the market are very slim to essentially nil.

Even if you don’t trust yourself to objectively invest in the market, and instead choose to trust someone to invest for you, Dalbar shows that there is a correlation between conflicts of interest and diminished returns amongst investment managers. Defined as the difference between potential investor earnings from a group of investments and the actual returns that the average investor actually receives, diminished returns are shown to be caused by the investor’s own behavior and there was no evidence to support that poor investment recommendations are material factors, irrespective of the source of such recommendations. In summary, even the investment picks of your used-car salesman uncle cannot consistently be faulted for your own lousy investment results after all.

Still think you have a shot at outperformance? For the past 30 years ending with December 31, 2015, the S&P index produced an annual return of 10.35% while the average mutual fund investor earned only 3.66% with a gap of 6.69% per year of diminished returns, predominantly due to investors consistently not staying the course and failing to have a long-term investment strategy.

Dalbar has outlined 9 key causes of poor decision making that are tied to how investors both think and act when making crucial and unfortunately detrimental investment decisions:

1. Loss aversion – expecting to find high returns with low risk

2. Herding – copying behavior of others even when faced with unfavorable outcomes

3. Narrow framing – making decisions without considering implications

4. Regret avoidance – Investors vowing to never repeat the same decision if it resulted in a previous loss (or missed gain), not accepting that future market behavior cannot be predicted.

5. Media response – reacting to news without objectivity

6. Mental accounting – taking undue risk in one area and avoiding rational risk in another

7. Optimism – bad things only happen to others

8. Anchoring – relating to familiar experiences when inappropriate

9. Lack of true diversification – reducing risk by only using different sources

Although individually these causes of poor decision making don’t seem so harmful, in fact, they are expanded and compound on one another. This becomes evident in the fact that equity mutual fund investors over the past 20 years haven’t managed to stay invested in their funds for more than 4 years, showing an inability to maintain consistent strategy and impeding their ability to follow S&P 500 trends which have demonstrably outperformed investors by a wide margin in the long run. Furthermore, the poor retention rates (i.e. rate at which an investor holds onto an asset) amongst equity, fixed income, and asset allocation mutual funds suggest that investors lack patience and long-term vision to stay invested. These poor retention rates combined with poor decision making shown above result in the earnings gap between average equity mutual fund investors and those who consistently held S&P 500 index funds over the past 15 years (4.67% versus 8.19% annualized return), a truly stunning difference in the long run!

In summary, the data shows that the average investor is both a hindrance to his own investment success and consistently choses high-fee products (mutual funds / unit trusts) rather than less costly index funds. These two reasons strike a double blow at investor success and make it highly unlikely that an individual active investor can outperform the market on a consistent basis. The odds of a win at a casino seem to be higher than in the equity markets for the average investor. Nevertheless, there is a glimmer of hope, which we shall discuss in future blog posts (hint: keep investment costs low and follow the advice of academics when structuring your portfolio).

Source: “Quantitative Analysis of Investor Behavior, 2016,” DALBAR, Inc. www.dalbar.com


Copyright © 2018 Marc Ikels Consulting. All Rights Reserved. 

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