Why Investors Earn Below Average Returns

Dalbar Inc. is a company which studies investor behavior and analyzes investor returns. The results of their research consistently show that the average investor earns below average returns. From 1986 to 2005 the S&P 500 Index was up 11.9%. The average investor earned only 3.3%.

Why is this?

Study after study shows when the stock market goes up, people pour money into equity mutual funds, and when the market goes down, they pull money out. They buy high and sell low. They chase trends, focused on what is happening right now.

What would cause investors to exhibit such poor judgment? After all, at a 12% return, their money would double every six years. Rather than chasing performance, an investor could simply have bought a single index fund and earned significantly higher returns. The problem is, although true, this does not make for exciting headlines.

Instead, we see headlines describing “A World Meltdown” published at a time when the market is down. People panic and sell at market lows. When the market reaches all time highs the headlines read “Tech Stocks, Everyone’s Getting Rich, Here’s How to Get Your Share”. People feel like they are missing out; they rush to invest, buying at market highs.

The hype and sensation created by such headlines is difficult to ignore. Some investors decide to try to play these market highs and lows. Dalbar has determined that these market timers fare even worse than most investors, having an average return of -2.8%.

Investors would be better served by developing a long term investment strategy based on academic research. As famed economist Gene Fama said in a 2003 interview, “Since we believe markets work well, we don’t try to anticipate or forecast events. We read the papers, but we don’t use them to form long term policy.”

What principles should be used to form long term policy? A good start would be following Modern Portfolio Theory, developed by Harry Markowitz. His research on diversification and risk won the Nobel Prize in Economics in 1990. Simply put, you invest your funds in several different asset classes such as large cap stocks, small cap stocks, international stocks and bonds. The amount of money you invest in each asset class depends on the return you want to earn and the level of risk you are willing to take. Once you develop your strategy, you let the markets do the work. You leave your funds fully invested throughout the ups AND the downs.

It’s been academically proven that this disciplined approach to investing delivers results. Yeah, it’s boring, but it works. The more you try to work your money, the less it will work for you. So turn off CNBC. Ignore the headlines. Develop discipline. Build a sound investment strategy and stick with it for the long run. Start following these principles now and years down the road you can be on of the few investors earning above average returns.