The Nine Reasons Investors Underperform Without Professional Management
There are multiple layers to the question: do I really need an investment advisor? Although there are no easy answers for everyone and every situation, data shows that the vast majority of retail investors are better off utilizing the services of an investment advisor as opposed to managing their investments on their own.
Why/how do investment advisors make a difference? Theoretically, no one has a greater interest than you in protecting and looking after your investments. However, your personal interest in protecting and looking after your investments may be the single greatest factor working against your investment performance. Most investors are risk-averse, biased creatures prone to putting too much credence into noise, trends and herd mentality.
Why do investors do so poorly? You have likely heard of the impact of the basic human emotions of greed and fear on investing—getting overly optimistic when the market goes up, assuming it will continue to do so, and wanting in on the action (GREED) and becoming extremely pessimistic during downturns and wanting out before losing everything (FEAR).
Why do we act this way?
In 2010, the Securities and Exchange Commission Office of Investor Education and Advocacy requested that The United States Library of Congress Federal Research Division prepare a report on the behavioral traits of U.S. retail investors. The report identifies nine common investing mistakes that affect investment performance. These traits are common behavioral characteristics that work against your investment returns, usually because you are too emotionally involved in the decision-making process.
The nine most common mistakes
Active Trading is the practice of engaging in regular, ongoing buying and selling of investments while monitoring the pricing in hopes of timing the activity to take advantage of market conditions. Active traders underperform the market. For the average retail investor, constant activity and speculative behavior are detrimental to long-term portfolio performance. A good advisor should assist you in creating a long-term strategic plan that does not involve churning or activity for the sake of activity.
Disposition effect is the tendency of retail investors to hold losing investments too long and subsequently sell winning investments too soon. Most people are risk-averse—even more so when handling their own investments. Loss-averse investors tend to sell high performing investments in hopes of offsetting losses from losing investments.
Paying More Attention to the Past Returns of Mutual Funds than to Fees. Many investors, pay too much credence to the past performance of mutual funds while virtually ignoring the funds’ transactional costs, expense ratios and fees. These types of fees can have a significant drag on the performance of your portfolio if they are not considered. Your advisor should account for fees in any analysis of your holdings. Remember, it is not only the performance of the fund that matters, but ultimately the value you get out of it.
Familiarity bias is the tendency of many investors to gravitate towards investment opportunities that are familiar to them. This bias leads to investing in glamor stocks or glamor companies, investing too heavily in a local stock, or employees investing too heavily in their employer’s stock. A good advisor will work to ensure you are aware of being overly concentrated in certain areas and will seek to keep your portfolio properly diversified to limit exposure.
Mania/Panic. Mania is the sudden increase in value of a “hot” investment, wherein the masses rush to get in on the action. Panic is the inverse, where everyone tries to abandon a sinking ship. What is the next “bubble”? When will there be another “crash”? With the advent of 24-hour financial news channels, social media and other concentrations of constant financial information, investors are now, more than ever, susceptible to mania and panic.
Noise Trading often takes place when the investor decides to take action without engaging in fundamental analysis. When investors too closely follow the daily headlines, false signals and short-term volatility, their portfolios suffer. Long-term plans require picking investments via economic, financial and other qualitative and quantitative analyses. Advisors take emotion out of the equation and seek to build your plan to weather manias and panics and keep you from following the herd fueled by the noise of the day’s leading story.
Momentum Investing is the practice of buying securities with recent high returns and selling securities with low recent returns, assuming past trends and performance will continue. Chasing momentum leads to speculative bubbles with the masses inflating prices. Similar to manias and panics, retail investors are often the last ones to know either way, causing them to often jump on a security experiencing momentum at the wrong time, usually buying high and selling low—with obvious detrimental effects on their portfolios.
Under-diversification happens when the investor becomes too heavily concentrated in a specific type of investment. This increases their exposure by having too many eggs in one basket. It goes without saying that any long-term investment plan requires diversification. However, investors generally need the assistance of an advisor to diversify correctly.
Naïve Diversification is the practice of an investor deciding to diversify between several investments in equal proportions rather than strategic proportions. Proper diversification in the investment arena is not simply putting X asset classes in X equal percentages. Rather, a proper allocation strategy should weight your differing investments in a manner aligned with your personal risk tolerance to build value over the long term.
By the Numbers
Historical data shows that retail investors make the same Greed and Fear mistakes time and time again; buying investments when prices are high and selling once they have fallen. According to the 2016 release of Dalbar’s Quantitative Analysis of Investor Behavior, the average investor in a blend of equities and fixed-income mutual funds garnered only a 1.89 percent net annualized rate of return for the 10-year time period ending Dec. 31, 2015. During the same period, the S&P 500 returned 7.31 percent—a clear underperformance by orders of magnitude against the index. The same average investor hasn’t fared any better over longer time frames. The 20-year annualized return comes in at 2.11 percent, while the 30-year annualized rate is just 1.65 percent vs. 8.19 percent and 10.35 percent respectively in the S&P 500.
Advisors don’t exist strictly to pick the best stock, mutual fund or ETF or to simply forecast economic conditions and make tactical decisions in a portfolio. While those are important components, an advisor should act as a buffer who puts space between you and your investments to take some of the emotion out of the decisions. The bottom line: the emotional connection between you and your money affects your decisions. Your savings represents security, stability and your goals. It’s more than wealth—it’s your future. With all of this on the line, it is virtually impossible for you to make consistently rational investment decisions over the course of your investing life.
The best advisors work with their clients to create strategic, properly-diversified, long-term investment plans. The plans must be tailored to the client’s personal risk tolerance and goals, while attempting to minimize fees and costs, as well as tax-drag.
Utilizing the assistance of an investment advisor will not alleviate all the risk associated with investing in securities markets. Nothing can take all the risk out of investing. However, a strong advisor can protect you against emotions, myopia and fixation on short-term results.
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David B. Mandell, JD, MBA, is an attorney and author of more than a dozen books, including Wealth Management Made Simple. He is a principal of the wealth management firm OJM Group www.ojmgroup.com, where Robert G. Peelman, CFP® is Director of Wealth Advisors. They can be reached at 877-656-4362 or email@example.com.