At the end of 2015, the S&P 500 had a 20-year annualized return of 8.2%. In contrast, actual investor return was 4.7%, reveals research from Dalbar Inc.
Why the 3.5% difference?
Some can be attributed to a lack of cash or a need to remove capital from the market (1.2%); some, to fund expenses (0.8%). The rest — 1.5% — can be blamed on investor behaviour.
“Based on this study, investor behavior was a bigger drag on performance than fees,” notes a Richardson GMP report.
To better understand behaviour, consider that sub-optimal decision-making is affected by both cognitive and emotional biases. The former impact perceptions, while the latter are due to distorted reasoning.
“Depending on what type of investor you are, some [biases] may be more applicable to you than others,” says the report.
For example, if you outsource investments, you might be more likely to suffer from loss aversion, status quo bias or framing.
“The good news is nobody suffers from all of them,” says the report. “The bad news is it is hard to know when each bias may impact your investment process.”
Learning more about potential biases can help you identify and defend against them.
How to control loss aversion
For example, loss aversion can lead investors to sell winners and hold on to losers.
That’s because the pain of loss is acute. Contrary to rational economic theory, such pain is about twice the pleasure experienced from an equal-sized gain.
To overcome this problem, remove the original investment cost from your decision process, says the report, and consider current market values and portfolio weights.
“For poorly performing investments, consider if the future prospects of the investment have changed or does the original thesis for owning still hold. Sometimes it’s just the cycle of the markets.”
For tips on defending against confirmation bias, read the full report.
For more insight on investor psychology and the consequences for investing, read the Dalbar research.