Why Do Investors Really Underperform Over Time?
While the inability to participate in the financial markets is certainly a major issue, the biggest reason for underperformance by investors who do participate in the financial markets over time is psychology.
Behavioral biases that lead to poor investment decision making is the single largest contributor to underperformance over time. Dalbar defined nine of the irrational investment behavior biases specifically:
Loss Aversion – The fear of loss leads to a withdrawal of capital at the worst possible time. Also known as "panic selling."
Narrow Framing – Making decisions about on part of the portfolio without considering the effects on the total.
Anchoring – The process of remaining focused on what happened previously and not adapting to a changing market.
Mental Accounting – Separating performance of investments mentally to justify success and failure.
Lack of Diversification – Believing a portfolio is diversified when in fact it is a highly correlated pool of assets.
Herding– Following what everyone else is doing. Leads to "buy high/sell low."
Regret – Not performing a necessary action due to the regret of a previous failure.
Media Response – The media has a bias to optimism to sell products from advertisers and attract view/readership.
Optimism – Overly optimistic assumptions tend to lead to rather dramatic reversions when met with reality.
The biggest of these problems for individuals is the "herding effect" and "loss aversion."
These two behaviors tend to function together compounding the issues of investor mistakes over time. As markets are rising, individuals are lead to believe that the current price trend will continue to last for an indefinite period. The longer the rising trend last, the more ingrained the belief becomes until the last of "holdouts" finally "buys in" as the financial markets evolve into a "euphoric state."
As the markets decline, there is a slow realization that "this decline" is something more than a "buy the dip" opportunity. As losses mount, the anxiety of loss begins to mount until individuals seek to "avert further loss" by selling. As shown in the chart below, this behavioral trend runs counter-intuitive to the "buy low/sell high" investment rule.
In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.
More importantly, despite studies that show that "buy and hold," and "passive indexing"strategies, do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits. But then again, since the majority of American's have little or no money with which to invest, maybe a bigger problem is the lack of financial education to begin with.