How to improve your returns

If you think most people are rational investors, think again.

Financial services market research firm DALBAR has surveyed individual households for more than 20 years and created their Quantitative Analysis of Investor Behavior (QAIB). This measures the returns of the S&P 500 Index against the returns of the individual investor.

Here are two surprising facts:

The S&P 500 Index had an annualized return of 9.14% for the period ending December 31, 2010.

The average equity fund investor only made 3.83%, ignoring taxes and inflation, in the same time period.

Source: Dalbar Inc, Quantitative Assessment of Investor Behaviour, 2011

Recently, a school of thought has emerged called behavioural finance. The key point of this discipline is that the decisions people make are influenced just as much—if not more so—by psychological and emotional factors as by logic.

Psychological and emotional factors lead people to buy high and sell low. They react to the latest news and make ill-timed changes in their portfolios. They make important investment decisions based on limited information, facts and research—on yesterday’s news.  A caring financial advisor who understands these factors and how these bad behaviours affect performance can help individuals manage their behaviour and achieve better financial results.

People value gains and losses differently, basing decisions on perceived gains rather than perceived losses. A loss has much more of an emotional impact than the joy of a gain.  Some studies suggest the pain of a loss is twice as great as the joy from a win. This is known as loss aversion. As a result, people sell winners quickly to consolidate the gain and hold on to losers too long because they don’t want to realize the pain of the loss. A caring behavioural advisor can help you through periods of market declines by offering perspective and sharing confidence.

Thanks to the modern media, we are inundated with news that has a strong negative bias and often manages to make good news seem bad.  Once an idea gets in our head, we look for information or ideas that confirm our preconceptions about an investment rather than for information that might contradict it.  A caring advisor can offer objectivity and insight while sharing facts and truly successful strategies.

Another bias investors have is overconfidence. Overconfident investors tend to be more active traders, presenting another problem. They believe they are better at choosing when to enter and exit a fund or markets. They must make two good decisions – when to buy and when to sell.  A financial behaviour coach can point out such errors and help build confidence based on an objective view of what really works.

Humans want to follow the crowd. This tendency can be deadly in investing. Average investors don’t research, read, or educate themselves so they often make decisions with limited information and follow the crowd right over the cliff.  Such peer pressure can be nearly impossible to resit, but a behavioral financial advisor can point out the many past occurrences of this tendency and help you stay on track.

We all want to be liked and in investing it is easier to promote a viewpoint that is consistent with the group consensus than to offer a contrarian one. After all, a large group can’t be wrong, can it?  An advisor who really cares is willing to offer a distinct and sometimes unpopular opinion precisely when it is most needed and realizes that fact are not subject to opinion polls.

Over a market cycle, emotions get in the way of logic. Traditional education and training doesn’t equip financial advisors to deal with the emotional side of decision-making. They have been taught modern portfolio theory and the efficient market hypothesis. They learn things like alpha, beta, and standard deviation, and used them to build portfolios for clients.  Much financial advice is logical but tragically incomplete unless it assigns a central role to behaviour management.  The most elegant portfolio will not do the job if an investor will not stay in it through market cycles.

The emotional right-brained side of people is especially dominant in times of economic uncertainty. People’s emotions are triggered and they revert to defensive behaviours because they feel threatened.  While additional left-brain knowledge can certainly be helpful, what people most need is to lean on a strong relationship with a dependable professional advisor who understands investor behaviours.

In the Dalbar study, they regularly find a difference of five to seven percent compounded over twenty years between what the equity market has gained and what individual investors with all their human emotional choices have gained.  The greatest challenge a financial advisor faces is to close this gap and help you achieve the very real benefits of long term equity investing.  This is akin to building an ark to protect clients from the storms and flooding.  Are you on board?