Over the past couple of years, the prerogative of investors has been to focus squarely on fees and active asset management’s inability to perform, or rather, their inability to outperform their benchmark. Rightfully so, and as in any industry the fees and performance of a “product” will always remain at the forefront of any investor’s mind.
What is not often talked about is that the fund or portfolio manager’s ability to pick the correct asset classes (and the weighting and instruments within these asset classes), is not the only source of returns for a client. Other parties that wield significant influence over total return include advisors and the investors themselves.
‘The Quantitative Analysis of Investor Behaviour’ report from Dalbar (commonly known as the QAIB), highlights the following:
- The average equity mutual fund investor underperformed the S&P500 by 4.7% (11.96% vs 7.26%)
- The 20-year annualised S&P500 return was 7.68% vs the average equity fund investors return of 4.79%.
- Equity fund retention rates are currently at 3.8 years i.e. investors stay invested for only 3.8 years before “jumping ship” to another fund.
Research shows that investors have underperformed primarily due to the following three primary causes:
Dalbar notes “The retention rate data for equity, fixed-income and asset-allocation mutual funds strongly suggests that investors lack the patience and long-term vision to stay invested in any one fund for much more than four years. Jumping into and out of investments every few years is not a prudent strategy because investors are simply unable to correctly time when to make such moves.”
Humans in general struggle against short-termism and are inclined to jump from investment to investment with little regard for what this means for their long-term objectives. Your best bet is to invest and to continue investing – time will take care of the rest.
Take note that fees although very important, are not the only source of major underperformance. Fifty percent of underperformance comes from psychological factors or irrational investment behaviours. These include:
Loss aversion: Fear of enduring losses. This normally takes place at the worst possible time i.e. selling when you should be buying.
Narrow framing: Making individual decisions without considering the effects on the total portfolio.
Anchoring: The process of remaining focused on what happened previously.
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 highly concentrated or correlated to other assets within the portfolio.
Herding: FOMO – Fear of missing out. Following what everyone else is doing, which leads to “buy high/sell low.”
Regret: Not performing a necessary action due to the regret of a previous failure.
Media response: Media bias towards sensationalism.
Optimism: Overly optimistic assumptions tend to lead to dramatic reversions when met with reality.
We must, however, remember that investors are only human, and we make silly mistakes. Thankfully, investors can focus on the above biases and channel the correct energy into mitigating them.
How? Either through following a step-by-step investment checklist and process, or by hiring a professional and well qualified financial advisor. A recent study by The Vanguard Group has shown that an advisor can add as much as 3% value (USD) per annum. Wow.
Whether you’re a seasoned professional or a novice, it is always advisable to have someone that will help keep you in line with your goals and objectives. During volatile times, advisors come in handy and should help you weather the storm. Even bouncing ideas off an individual should prove useful. I would go as far as stating that no investment decision should be made in an individual capacity. Our minds are simply not wired to process and mitigate all the possible scenarios and biases. Although we’re not robots, we must put checks and balances in place in order to beat our natural, biased instincts.
Perhaps it’s time investors start concentrating more resources on themselves and their cognitive biases. After all, asset management fees can only be dropped to a finite level and we’re very close to it already.