3. Inefficient Trading. Many investors tend to move in and out of positions in an inefficient way, reducing their potential profits. This may be because individual investors are often overly confident in their own abilities to beat the market, and thus trade excessively and hurt their portfolio performance.
Market Realist – The graph above shows the annualized ten-year returns from the U.S. equity (SPY) and fixed income (BND) markets compared to individual investors, as per findings from the DALBAR “Quantitative Analysis of Investor Behavior Report 2014.”
The S&P 500 (IVV) gives annualized returns of 7.4% over a ten-year period, whereas international stocks (EFA) give returns of 6.9%, bonds and Treasuries (TLT) give 4.6%, and municipal bonds give 4.3%. The average equity and fixed income (IEF) investor, in comparison, earns meager 2.6% returns over the same period, whereas an individual fixed income investor earns only 0.6%.
Market Realist – Academic studies have often shown that an individual investor doesn’t outperform the markets in the long run. The graph above shows how well an average equity investor is able to “beat the market.”
Market Realist – Trading excessively and exiting the markets whenever there’s a negative movement can cost you heavily. The graph above shows the effects of being out of the market during strong market rallies. You can see by looking at the S&P 500 (SPY) from 1996 to 2005 that missing the top ten market days reduced the returns by more than half.
Investors also often make the cognitive mistake of extrapolating from past returns, buying assets whose prices have gone up in the expectation that prices will continue to increase. At the same time, people tend to be more likely to get rid of stocks that have done well in the past and to keep the losers so as to avoid the mental pain associated with realizing losses. In behavioral finance, this latter concept is known as “the disposition effect”, and it’s particularly striking considering that based on tax considerations, people would be expected to sell losers to exploit capital losses and defer taxable gains.
Market Realist – Read on to the next part of this series to learn what you can do to avoid missing out on returns.