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Why the Average Investor Underperforms the Market

Lanning Admin

June 15, 2022

Why the Average Investor Underperforms the Market

Annually, various organizations release studies that show that average investors underperform the markets, sometimes as much as 50% less, a frightening number for those do-it-yourselfer investors on the verge of retirement.

Why?

The average investor’s challenge in making money in the markets is not fees, lack of intelligence, lack of information, or unwillingness to take risk. The challenge is one simple thing: Patience.

In this article, we will discuss the emotional cycle of investing and why it causes so many people to fail. We will also offer some tips on how you can break free from this cycle and achieve better results.

 

Buy Low, Sell High

To state the obvious, investors make money by buying low and selling high. That does not mean they need to buy at the bottom and sell at the top, but they have to sell the asset for more than what they purchased it for. We generally refer to this as profit.  Successful investors make a profit.

For the average investor, this is harder than it sounds.

 

Underperformance Is No Secret

It’s no secret that the average investor tends to underperform the market. Studies come out every year proving this fact. The Dalbar study is probably most well-known.

Dalbar is a Boston-based research firm that has been studying investor behavior for over 30 years. Every year, they release a study called the Quantitative Analysis of Investor Behavior (QAIB). The study looks at the effects of emotions on investing decisions.

 

What the Study Shows

The Dalbar study generally shows that the average investor underperforms the market by a wide margin. For example, in 2018, the S&P 500 index returned -4.38%. The average equity mutual fund investor was down -9.42%. That’s more than double.

Over a 30-year period ending on 12/31/2021, the average equity fund investor made 7.13% versus the S&P500, which returned 10.65%.  Three percent may not mean much until you realize that the average investor has $800K at the end of that period and the S&P500 would have returned over $2M in the same time period.

(Important side note:  This is not to advocate buying an S&P Index Fund and setting it and forgetting it.  That’s a whole different problem entirely too long for this blog post.)

 

Why Does This Happen?

The Dalbar study attributes this underperformance to bad timing. Investors tend to buy when markets are high and sell when markets are low.

They buy after a period of good performance (called chasing returns) and sell after a period of bad performance (called panic selling).

The study shows that, on average, investors hold onto their investments for only four years. That’s not enough time to ride out the ups and downs of the market. Reasonable investor minds can differ on how long a market cycle would be, but five years is probably the shortest timeframe.

 

The Classic Example

This tends to be what happens.

The Average Investor go to a barbeque with friends. A friend there says, “Hey, I own ABC stock and I’ve made 10% in the last two months. You should buy some.”

Average Investor thinks, “No, I always get into trouble when I listen to that person, and I’m not going to do it.”

Average Investors goes over to the same friend’s house for Thanksgiving several months later. The same friend says, “Hey, have you bought ABC stock? I’m up 20%.”

Average Investor goes home and buys ABC stock. It goes up 10%. Average Investor thinks s/he/they is a genius.

Then, in the natural cycle of things, the stock starts going down. Average Investor’s friend assures Average Investor that it’s still a good investment. Average Investor decides to hang in there.

The stock goes lower. Average Investor starts to sweat. It goes even lower, and now Average Investor is angry and a little panicky.

The stock takes a breather and goes up a little, but the next day it’s down again. Average Investor thinks, “That’s it! I’ve had it!” And sells.

Average Investor sold at a price lower than what s/he/they paid for it and lost money.

This is why average investors tend not to do well.

The friend that stayed in says to Average Investor six years later, “Aren’t you glad you bought at ABC stock? It’s doing so well!”

Average Investor, of course, says nothing out loud while going crazy inside.

 

What Can You Do About It?

If you want to be a successful investor, you need to be patient. You need to stay invested through the good times and the bad times. You need to resist the urge to chase returns or sell in a panic.

Of course, this is easier said than done, but there are things you can do to help you stay disciplined.

  1. Invest regularly. Investing a set amount of money on a regular basis (e.g., monthly or quarterly) can help you stay disciplined. This is often called dollar-cost averaging. When you invest regularly, you buy more shares when prices are low and fewer shares when prices are high. Over time, this can help reduce the effects of bad timing.
  2. Create a plan and stick to it. A written investment plan can help keep you focused on your long-term goals. It can keep emotions out of your decision making. Once you have a plan, review it periodically to make sure it still aligns with your goals and risk tolerance.
  3. Make mid-flight corrections sooner rather than later. Related to #2 above, if you do panic and sell, you need to immediately create a plan to get back in if it is your intention to be a long-term investor.  Timing the market rarely works but delaying getting back into the market can be disastrous when you miss market recoveries.
  4. Expect downturns. They are part of the investment world and the investment cycle. They’re normal and healthy. Adjust your investments to align with your tolerance for losing money so that if your balances are down, you can more easily accept them.
  5. Stay focused on you and your goals. Listening to investors lament their returns, either out of greed or fear, is a pet peeve. What difference does it make what you did or did not earn if you have a plan and it’s working? If your investments are making your life’s plans work, you’re actually perfectly on track.
  6. Have “play” money. If you like to play the market or want to be able to invest in things your friends are investing in so you can join in the camaraderie, have a stash of money that is completely independent of your financial plan. Consider it “money I could flush down the toilet and not worry.” Go make all the emotional investments and mistakes you want with it completely guilt-free and for the sheer fun of it.
  7. Watch your biases. The big one is confirmation bias.  This is the tendency to pay attention to what thought you want to affirm and ignoring information in direct contradiction.  Widen your lens and bring in other viewpoints.  Should you really buy?  Sell?  What writing is on the wall that you’re not noticing?
  8. Work with a financial advisor. A good financial advisor can help you develop and stick to your investment plan. They can also provide guidance, pull you off the ledge, and be a sounding board when markets become volatile. And they will be volatile.

 

The Bottom Line

Emotions are a big reason why the average investor underperforms the market. By understanding this, you can take steps to avoid making the same mistakes. Investing regularly, having a written plan, and working with a financial advisor can help you stay disciplined and achieve your long-term investment goals.

If you want to talk further about how to keep your emotions out of your investment decisions, please reach out.

 

Lanning Financial Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

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