TWO REASONS WHY INVESTORS UNDERPERFORM
10/05/2016
Stock market investors underperform the stock market by a substantial amount every year. There are probably many reasons for this but I believe there are two that stand out. A recent study compared the returns investors receive relative to the market.
It found that the returns investors actually earned were 4.66% less than the S&P 500 index earned over the last 20 years. Using the numbers in the study, a starting account value of $100,000 invested for 20 years would have grown to $275,000. The S&P index account value would have been $654,000 on an investment of $100,000 over the same time period. So what would cause a $379,000 difference?
I believe the first reason is market timing. Individual investors try to make decisions about when to put money into stocks and when to take money out of stocks. We know the market is unpredictable but investors tend to put money in the market when it is up and take money out when it is down. We can see this in money flows into and out of mutual funds during extremes in the stock market. If you are buying high and selling low it will have negative effect on your return.
Investors are generally overconfident about their own investing skills. They also believe since it’s their money they are supremely qualified to manage it. Yet they make critical market timing mistakes. Just because you are an expert in your field of study or work does not make you an investing genius. Because you are proficient and confident in those areas you are not likely to translate those skills to investing. Overconfidence in areas you are not proficient in can cause costly mistakes. Only education, hard work and most of all experience in the field of investing can make you a good investor.
Investment decisions are generally emotional not rational or analytical. The decision to get out of the stock market is usually made after the market has gone down substantially and the word “crash” is in the headlines. Conversely, when the news is good and the market is up 20 or 30% then the individual investor decides to jump in. This behavior is extremely detrimental to your investment returns.
I know what some of you are thinking. You are thinking that’s not me because I just buy and hold. When there is bad news you just bury your head in the sand and never open your retirement or brokerage statements. Or you just never do anything ever. Yes, buy and hold is better than panicking but I don’t believe in buy and hold forever. Even buy and holders tend to add money to their portfolio only after the markets have moved up substantially. You should take advantage of market volatility rather than being an ostrich and buy a little when others are panicking and lighten up some when others are jumping in with both feet.
The second reason investors underperform the market is due to the expenses they pay. Most investors don’t know what they are paying and don’t care. They don’t see how a few dollars here and there can make any difference at all. They don’t see the charges and fees so therefore they don’t exist. The reality is that a large portion of the 4.66% underperformance per year in the study may be due to the fees and expenses investors pay. It is not unusual for an investor to pay 2% of their account balances per year in fees. In general, the less you know about an investment and the more complicated an investment is the higher your fees are.
If you just underperformed the S&P 500 by 2% per year instead of 4.66% for the same 20 year period you would pay $201,000 in fees. That’s right. On a $100,000 investment over 20 years you would pay $201,000 in fees and only have $453,000 at the end. Remember the return of the S&P 500 was $654,000 over the same period.
If again you are saying that’s not me, remember you don’t see these fees they are taking out of your account. If you own a mutual fund or annuity you never see the fees because they take them out before they calculate your balance. The same goes for many investments. The fees are hidden on purpose you have to be a detective to figure them out and they don’t make it easy. If you have some kind of managed account there are two sets of fees, one for the investments used and one for the money manager.
Bill Oldfather is a fee-only financial planner and investment advisor. Oldfather Financial Services is an SEC Registered Investment Advisor based in Kearney NE. Email to bill@oldfatherfinancial.com