According to financial research firm Dalbar, the average investor is below the median when it comes to their investment returns. From their 2020 study on investor behavior, the average stock mutual fund investor earned 5.04% per year over the past 30 years. For comparison, the S&P 500 earned 9.96% over that same timeframe.
What does that gap in performance mean in dollars?
The average investor would have turned $100,000 into $437,160. But someone who was able to hold the S&P 500 would have turned their $100k into $1.7 million!
It’s important to note that this data is from mutual fund investors—not day traders. But why would mutual fund investors underperform? After all, mutual funds were meant to make investing easy and accessible.
The reason the average investor fails to capture the full returns of the stock market is because of poor timing when buying and selling. These ill-timed decisions are motivated by our own emotions.
The investor’s cycle of emotions
During a typical market cycle, investors experience a rollercoaster of emotions—always connected to the performance of their accounts.
During rising markets, investor excitement eventually turns to euphoria as seemingly everything is making money. People overextend themselves, take on extra risk, and buy at higher prices.
Then prices start going down. At first, investors deny anything wrong is happening and assure themselves it’s only a minor correction. Denial turns to anxiety and then to fear as the correction is deeper and longer than they thought possible. Finally, they panic. To “stop the bleeding”, investors sell.
It’s at this point when the “smart” money starts buying. Large institutional investors are the first to recognize these low prices are the best time to buy. As the market starts recovering, weary investors are skeptical that the rally can last.
As things keep improving, higher prices turn skeptics into hopefuls. Soon these same investors will start feeling optimistic again. Around this point, they will return to the market and become buyers.
Buy high, sell low?
It’s no wonder the average investor underperforms. What other product on earth do people refuse to purchase while on sale, yet rush to buy at higher prices?
One reason our emotions get in our way is due to recency bias. This cognitive bias explains why we focus so much on our short-term performance. Instead of remembering the market’s ability to deliver superior long-term returns, we recall only the most recent trends.
In rising markets, we buy what’s working now and forget about diversification. In the depths of a bear market, we wonder how stocks can ever recover. “This time is different” replaces “buy low”. As a result, our emotions cause us to buy high and sell low.
How to make investing simpler
For most people, dollar cost averaging through automatic transfers is the most effective way to avoid poor market timing. This takes the guesswork out of knowing when to invest. Sometimes you will invest at super high prices. That’s okay because you will also buy more shares when prices are low.
The second step is to recognize your own cycle of investor emotions. Are you taking on too much risk because you’ve missed out on the recent highs? Or are you buying into the “this time it really is different” bear market panic?
Emotions are part of investing. It’s okay to be excited when prices are high and scared when prices are in the gutter. Just don’t let these emotions trick you into achieving below-average returns.