One of the biggest problems investors face – is themselves!

Numerous academic studies prove that investors consistently underperform the investments they invest in. They face the same emotional issues as gamblers – taking too much risk when they’re winning, and chasing losses, or running for the hills, when they’re losing.

How the average investor lost money in the best performing fund of the decade

The CGM Focus Fund was the top performing US mutual fund in the decade from 2000-2010, rising more than 18% annually and outpacing its closest rival by more than three percentage points, however, the average investor in this top-performing fund lost an average of 11% a year over the same ten-year period. How is that possible?

It’s quite simple: investors poured money in after the fund had a good run and ran for the exits when the fund had a bad run. Bob Veres, the editor and publisher of Inside Information, says, “There have been credible studies showing that the average investor underperforms the market, and this illustrates exactly how it happens. Right after an investment generates strong returns, people tend to jump on the bandwagon – and then they experience the subsequent return to reality. When an investment is struggling, people tend to abandon it, and miss out on its recovery. Missing the upside and catching the downside, consistently, is human nature, and perfectly understandable behaviour. But it inevitably leads to dismal investment results – as it did for the battered, unhappy, money-losing investors in the best-performing mutual fund of the 2000s.”

A further example highlights this point. The table below titled, “Average Mutual Fund vs. Average Fund Investor” illustrates some of the details of the Trzcinka study cited by Jason Zweig. The large gap between the funds’ and shareholders’ returns was a shock to even the researchers. The reason for this gap is attributed to active investors who followed the destructive behavioural patterns that Dalbar Research had been describing since 1994. These patterns include, waiting for funds to have a good year or two, followed by pouring in a flood of cash just before the fund reaches its peak. Then they ride the fund to near bottom and sell.

Back in 2006, Morningstar posted a short article on the differences between what funds earned, and what investors earned. The article found further evidence that investors chase performance, and that this behaviour works against them, resulting in more risk and lower returns. The lesson to be learned is, that while asset allocation is the most important determinant of the returns of a portfolio, the ability to stay the course and adhere to the plan is the most important determinant of the returns “actually earned” by investors. To succeed as an investor, you need a good plan, but, if you have a plan that you can’t (or won’t) stick to, then that is effectively the same as not having a plan at all.

Becoming a better investor starts with understanding our own weaknesses

Humans are creatures of emotion, not logic, and fund managers face a constant battle to retain investors whenever their fund undergoes a losing period. As an analogy, think of a fund going through a losing period like a plane going through turbulence. The fund manager, like the pilot, assures everyone that it is normal turbulence, there is nothing to fear, and that they should just remain in their seat, and they will arrive safely at their destination. The bottom line is – all investments go through losing periods from time to time, so investors should be prepared for these inevitable events. The key to staying the course, is being psychologically prepared ahead of time, knowing that periods of losses will occur, and understanding what the possible range of returns are from various investments.

To reduce the possibility of doing psychological damage to your portfolio, consider the following points:

  • Before investing, carefully think about your long-term risk and return objectives. Why take more risk than you need to in order to achieve your return objectives, especially if taking more risk than you can psychologically endure will mean being shaken out of your investments at the worst possible time;
  • Choose your asset allocation wisely, creating an efficient portfolio, that should deliver good risk-adjusted returns over the long-term, in line with your risk and return objectives;
  • Understand each part of your overall portfolio, why it was chosen, why it has the amount invested (weight) that it does, and why it is necessary. Know where your returns are coming from, and under what circumstances you can expect each investment to perform well, and what circumstances are likely to cause it to perform poorly – forewarned is forearmed, and the more knowledgeable you are about your investments, the more comfortable you will be with them;
  • Look for highly diversified, lower volatility investments, as higher volatility investments play havoc with our emotions, i.e. it’s hard to stay rational if you lose half of your capital;
  • Ensure your asset allocation will allow your portfolio to perform well through a wide range of economic conditions, which will inevitably occur over your investment lifetime. This will further reduce volatility, lower your stress levels, and make it easier to stay in your investor seat for the long term. If we assume that the average investor starts investing at 25, and lives until they are 85, that is 60 years’ worth of investing. No one knows what the future holds, but we can be certain that we will see a wide range of conditions and a lot of change over a period of 60 years. Prepare yourself for the long haul – investing is a lifetime journey;
  • Seek investment managers who use an academically sound, disciplined, quantitative approach, rather than an ad hoc investing approach, as investment managers without a disciplined strategy may also be swayed by emotions in times of large gains or losses;
  • Don’t change your asset allocation based on short-term performance, i.e. only change it if you are confident it will improve your long-term risk-adjusted returns, either by lowering risk, increasing the return – or both; and
  • Enjoy learning about and monitoring your investments, without treating investing like a hobby, or getting bogged down in day by day, or month by month, market movements. Investing is serious stuff, but it doesn’t have to be tedious, and the more you manage risk carefully, the more psychologically comfortable you will be with your investments. This will allow you to focus on planning for a bright, long-term future.