Investment Strategy: Learning from past mistakes

Long-term US research shows investors are frequently driven by fear and greed in their decisions – for example, selling out in weak markets. However, more recent findings show the average investor has learned from some past mistakes.

By

By Sally Campbell, Executive Director, JBWere

Financial commentators love to suggest investors are all incapable, or at least unwilling to learn from past mistakes. We have repeatedly seen investors chasing performance, and the old adage, that greed and fear drives investor behaviour, frequently appears in the headlines. The good news is recent US research shows the average investor has learned from some past mistakes, but there remains considerable scope for further improvement.

Dalbar is a US research organisation which has undertaken research into US investor behaviour for more than 20 years. It recently released its 2014 research edition measuring the returns of the average investor. This research reviews applications and redemptions into mutual funds over time. The aim is to calculate the return a typical investor has actually received, taking into account how long they were invested.

The long-term experience has shown that the average investor generated less than half of the return possible from a passive market investment. For example, over 20 years, the annual investor return in an equities fund was only 5.02% versus the market return (as represented by the S&P 500 Index) of 9.22%.

The results are even more shocking for the average fixed interest investor. For instance, over 20 years, an investor’s annual return in a fixed interest fund was 0.71% versus 5.47% for the market (as represented by the Barclays Aggregate Bond Index) and 0.63% over 10 years for the investor versus 4.55% for the market.

How is this possible?

This analysis shows investors are invest in managed funds after the funds have generated strong performance, which is often followed by periods of moderate or even negative performance. The fear of missing out is leading to investors actually missing out.

Investors are also likely to be crystallising their losses during weak market conditions due to fears of losing even more and only reinvesting once investment markets have rebounded. Unfortunately, this locks in the loss and removes the possibility of capturing any rebound in equity markets. The combination of these two actions has resulted in significant under-performance for the average investor versus the market.

Are there any positives from this analysis?

Yes. Importantly we have seen an improvement in the relative performance over recent times. Over the last five years, the gap between the average investor and the market return has narrowed. This is both within equities and fixed interest, although more so within equities. For example, over five years, the average investor return in an equities fund was 15.21% versus a market return of 17.94%.

Whether it is a focus from the industry on better education; or the significant impact that both the recent tech boom and GFC have had on investors, we have seen an improvement. But there is still a long way to go. It is unacceptable that the average investor still performs well below market (benchmark) returns.

Another positive outcome of this research is that the average investor in asset allocation funds (typically known as balanced funds in Australia) has also seen a significant improvement in their returns over the last five years in particular.

Whilst over the last 30 years the average investor in asset allocation funds failed to even keep pace with inflation, the results over the last five years are substantially different with returns far in excess of inflation. We have also seen the average investment period within asset allocation funds rise from three years in 1994 to five years today as investors continue to embrace a longer term outlook.

How can we ensure this trend of improving investment outcomes for the average investment continues?

Unfortunately, volatility in investment markets is unlikely to go away. We need to accept that it exists. We need to set appropriate and realistic investment goals and constantly assess our performance in light of those long term goals, rather than focusing on short term outcomes.

For further analysis, download the full report.