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Dalbar is an independent research firm that evaluates mutual fund investor returns on an annual basis. The research uses data from the Investment Company Institute (ICI), Standard and Poor's and Barclays Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks. The annual Quantitative Analysis of Investor Behavior (QAIB) covers the time period ending December 31, 2010.
For the 17th year in a row, the study shows that both equity and fixed income investors underperformed the broad indices. For 2010, equity investors trailed the S&P 500 by almost 1.5% and fixed income investors underperformed the Barclays Aggregate bond index by more than 3.5%.
Why do average investors underperform broad indices by such significant amounts? The primary reason is investor behavior - reacting to market movements and news results in never staying invested long enough to derive the benefits of a long-term strategy. Retail investors, in particular, tend to abandon investing at the most inopportune times, often in response to bad news or market corrections.
Behavioral finance experts have identified psychological factors that help explain why investors often make buy and sell decisions that contradict best practices. These include:
- Loss aversion – expecting high returns with low risk. Searching for investments that don’t exist, resulting in taking no action or selling at an imprudent time.
- Narrow framing – making decisions without considering all implications, often resulting in quick decision making.
- Anchoring – relating familiar experiences, even when inappropriate, leading to unrealistic expectations.
- Mental accounting – taking undue risk in one area and avoiding rational risk in others.
- False diversification – seeking to reduce risk by using different sources instead of understanding how asset classes interact.
- Herding – copying the behavior of others even in the face of unfavorable outcomes.
- Media response – reacting to news without reasonable examination.
- Optimism – holding onto poor investments after it becomes evident that they are not likely to recover.
In order to achieve desirable results, investors must manage the behaviors that destroy long-term success. Working with an advisor can often be helpful in this regard. It is also important to understand your risk tolerance and construct a portfolio that does not exceed the level of volatility that you are comfortable with. Taking excessive risk often leads to decisions to exit the market at exactly the wrong time.
