The risk of being the average investor

Thought Leadership on Corporate Financial Wellness presented by Raskin Gobal.

Investors often have difficulty understanding the relationship between risk and return in relation to investment portfolio performance.

“Return” is what an investment yields, or the profit made by holding an investment over a period of time.

“Risk” refers to the probability of underperforming the market benchmark, or failure to achieve projected returns.

The more risk investors are willing to take, the more likely they are to earn returns that have a larger deviation from mean or average returns over the long term. Higher risk may result in higher or lower returns than those achieved by lower-risk investments.

As a whole, though, investors tend to underestimate the potential risk of their investments to pursue high returns.

In the most recent version of its Quantitative Analysis of Investor Behavior (“QAIB”) study published in 2015, Dalbar, Inc., a research and analysis company, reported data on “average investor” and “average equity investor” behavior. The Dalbar QAIB glossary defines the average investor as “the universe of all mutual fund investors whose actions and financial results are restated to represent a single investor.” QAIB uses the term “average equity investor” to refer to the subset of mutual fund investors invested solely in equity funds.

According to the QAIB study, while the S&P 500 averaged 11.06% for the 30-year period from 1985 to 2014, the average equity investor averaged only 3.79% per year. [1, 2]

The Barclays Aggregate/Bond Index for the same 30-year period returned 7.36%, which means an investor could have done better than the average equity investor simply by holding relatively low-risk fixed income investments. [3]

Said another way, what investors want is equity returns with fixed income risk, but what we frequently see is just the opposite: T-Bill-type returns with stock market risk.

What drives the average investor to this outcome?

It comes down to the psychology the average investor brings to investing, not having a clear understanding of the risk/return trade-off, and the resulting behaviors of both of these.

Here’s how the average investor typically behaves and why:

The average investor alters their funds and portfolio mix too frequently. The QAIB study reported that, in a 20-year analysis, the average investor changes his or her portfolio every 3.41 years, selling previously purchased mutual funds and reallocating them to new funds. [1] This behavior indicates that investors are constantly in search of a portfolio that works – they want high-returning assets with little or no downside volatility. However, doing this is extremely detrimental to the accumulation of wealth.

The average investor chases “hot” asset categories. Related to the behavior above, the average investor seeks out what he or she thinks are high-return asset categories, without even realizing they are doing it. For example, when tech stocks are hot or growth stocks are hot, or when stocks lose 30% while fixed income is gaining 4%, the average investor will switch to the hottest asset category relative to the others.

The average investor breaks the rules of investing by buying when prices are relatively high and selling when prices are relatively low, ultimately forsaking diversification. As a result of this behavior, the average investor usually underperforms the market. We’ve all heard day-traders brag about chasing the winners and dumping the losers. But if you’re always buying stocks or funds when they’re high and you’re always selling assets that are low, you have no dissimilar price movement. Everything is doing the same thing at the same time, and your entire portfolio ends up in only one or two asset categories.

The average investor often panics and takes money out of the stock market. The trigger is typically the media. The average investor reads magazine articles, listens to business commentaries and consumes other news media hype stating that the equities market is on the downslide and may not recover. It’s no wonder investors panic. But rushing to place your money in fixed income asset categories is not the answer.

Clearly, being the average investor is nothing to strive toward. But how do you become above average?

Fortunately, the answer is pretty simple: Avoid “average investor” behaviors, establish a well-balanced, diversified portfolio and work with an experienced financial coach for the long haul. After all, everyone needs a trusted advisor who knows how to talk them off the ledge when necessary.

[1] The mutual fund returns are net of all fees and expenses and the equity market return represented by the S&P 500 has no fees or expenses deducted.

[2] DALBAR’s 2015 Quantitative Analysis of Investor Behavior (QAIB) is the 21st annual edition of a report that examines the returns investors actually realize and the behaviors that produce those returns.

[3] Barclays Aggregate/Bond Indices

Click here for more Thought Leadership from Raskin Global.

Leonard Raskin is a Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS). Securities products and advisory services offered through PAS, member FINRA, SIPC. Financial Representative of The Guardian Life Insurance Company of America® (Guardian), New York, NY. PAS is an indirect, wholly-owned subsidiary of Guardian. Raskin Global is not an affiliate or subsidiary of PAS or Guardian. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice. 2016-29413 Exp 10/18