Being human is one of the biggest threats to your investment portfolio
Time after time, year after year, the average stock market investor earns a significantly lower return than the average fund earns. A study carried out by DALBAR, a leading financial services research firm, that looked at returns over 20 years to the end of 2011 found that the average investor earned less than 50% of the return achieved by the average fund! So where are investors going wrong?
People make poor investment decisions because they are human. Our instincts encourage us to buy after results have been good and to sell after results have been poor. Exactly the opposite of what we are told to do, i.e. buy low and sell high.
To understand why, you need to understand two investment terms – time-weighted returns & money-weighted returns for funds.
- The time-weighted return which is the return typically reported, is simply the return for the fund over time.
- The money-weighted return on the other hand calculates the return on each of the Euros invested. These two calculations can yield very different results for the same fund.
So let’s look at an example to explain the difference between the two.
Say, a fund starts with €100 and goes up 20% in year 1. It’s now worth €120. The next year however, let’s assume it loses 10% (-€12). So the €100 invested at the beginning is worth €108 after two years and the time-weighted return is 3.9% p.a.
Now let’s say we start again with the same €100 and the same first year results of a 20% return. Investors see this very good result, and because they assume the good returns will continue (remember we’re human!), they pour an additional €200 into the fund. So now they have €320 at the end of year 1 — the original €120 plus the additional €200 invested. The fund then goes down 10% in year 2, now causing €32 of losses.
The fund will still have the same time-weighted return, 3.9% as this is calculated on the fund’s performance over two years (an increase of 20% in year 1, a drop of 10% in year 2).
But now the fund will be worth only €288, which means that in total, investors put in €300 — the original €100 plus €200 after year one — and lost €12.
So the fund has positive time-weighted returns but negative money-weighted returns. Investors’ tendencies for buying high and selling low means that investors earn, on average, a money-weighted return that is less than 50% of the market’s return (as per above). The results of our decisions with respect to timing are simply appalling.
The DALBAR study also identified something even more startling. An investor committing money on a regular basis to the stock market fared even worse than the lump sum investor, with a return of just 3.2%. So what are we to make of this?
Patterns of stock market returns are important to the regular investor. Investment strategy cannot be simply ignored if an investor is committing money on a regular basis. You can’t just throw money blindly at the market.
To investors that commit lump sums to the stock market, you’re pre-disposed to undermining your return through your own actions. Emotions, like hair growth or your heartbeat can’t be controlled. You need to take the emotion out of the investment decision making. To do this, at a very minimum, have a proper plan when investing and seek external validation of your plan. Or better still, employ an expert who won’t get caught up in the emotion of the investment decisions to invest the money on your behalf.
Where do you find and get access to such an expert? Well this is where we come in. It’s our job to show you the range of investment options available to you, to talk you through the different funds and fund managers available and to help you find the one that best suits your needs. We’re on your side and again, will be able to leave the emotion out of the decision making!
If you have any comments or queries in relation to this article, we look forward to hearing from you!