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October 30, 2018

Why Average Investors Underperform the Market

After a summer of fairly low volatility, it appears that the tides could be changing. Interest rates have risen dramatically in recent weeks and the effects are beginning to spill over into the equity markets.

Popular trades, like semiconductors or information technology, have faltered in recent days. Analysts fear that the Federal Reserve may take monetary tightening too far, too quickly.

Talking heads in the media have latched onto these concerns. As an individual investor, it’s in your best interest to ignore these day-to-day movements in the market and instead focus on the quality assets you’ve accumulated in your portfolio.  

Below is a graph that shows how the average retail investor has historically stacked up against a variety of popular asset classes. 

Admittedly, this data is outdated, spanning the 20-year period from 1993 to 2013.  However, 20 years is long enough to identify a strong trend. And while the best performing asset classes have changed during the past five years, I highly doubt that the average individual investor has evolved to the point that his or her returns wouldn’t still be sitting somewhere towards the bottom end of this chart. 

I saw this chart early on in my investing career and instead of getting discouraged, I decided to investigate why the average retail investor fails relative to other asset classes. It didn’t take long to realize that there are two primary issues that we all have to overcome: fear and greed.                               

Humans are a flawed species. We’re emotional creatures. Often, in real life, that’s a good thing. Joy and love, heartbreak and loss, hope and longing — these are all sensations that make life worth living. However, when it comes to the stock market, emotion is best left at the door. It leads to undisciplined, irrational decisions, and often these emotions lead to losses. 

Everyone knows it’s best to buy low and sell high. This is an easy enough principle to understand. However, it’s not easy to enact. 

Most people love price reductions when they’re available at the grocery store, in the shopping mall, or on an e-commerce site. However, people tend to be afraid of discounts in the stock market.

On the contrary, many retail investors are prone to the herd mentality, where there is perceived safety. They’re willing to chase momentum, allowing the fear of missing out to overwhelm their good sense. Far too often, the average investor has shown a willingness to sell at bottoms and buy at tops, which is why their performance is so low relative to other asset classes. 

Inactive Management Beats Emotion

A few years ago the financial media jumped all over reports of a Fidelity study regarding its highest performing individual investor accounts. Guess which ones they were?  Highly educated individuals? Wise elders with decades of experience? Some fancy wiz-kid using computer algorithms to dictate his strategy? No. 

According to the reports, Fidelity’s top performing account holders were those who had either died or totally forgotten that they had an account. 

What’s the common theme here? The accounts were left untouched. Human nature wasn’t able to negatively impact the returns that the compounding of the stock market has proven to produce over time.  

I’m not saying that the average investor should blindly (or worse, blissfully) buy and hold every stock in their portfolio, but the data does point towards the benefits of inactivity. 

Famed investor Warren Buffett spoke on this issue in his 1996 letter to Berkshire Hathaway shareholders asserting, “Inactivity strikes us as intelligent behavior.”

 Mr. Buffett goes on to say that he wouldn’t dream of selling the highly profitable subsidiaries that his holding company Berkshire Hathaway (NYSE: BRK.B) owns because of fears of interest rate hikes or because some Wall Street analyst changed his or her opinion. So, why should he view minority equity positions any differently? This is the view that individual retail investors should take. It’s best not to view one’s holdings as simply ticker symbols to be easily traded.

Stocks aren’t baseball trading cards. Instead, investors should view their portfolios as a business and themselves as partners with the companies that they own.  This mindset leads to a focus on profitability and cash flows, rather than rash sentiment. It also leads towards a long-term outlook, which is probably most important of all. Fear is intensified when investors are overly concerned about the here and now. Hedge funds often underperform the broader markets because of a focus on quarterly results. CEOs of public companies often make the same mistake.   

The average investor isn’t beholden to these time constraints. During this period of increased volatility, it’s important to remember that the American stock market has been generating real wealth for patient investors for longer than any of us have been alive. I agree with Warren Buffett: American exceptionalism is real. And I don’t see any reason why this truism should change moving forward.
Courtesy of Nicholas Ward, Investing Daily (More from Investing Daily Here
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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