Human Emotion Kills Investor Returns

Tim Fortier |

InvestingSince 1994, Dalbar, Inc. has been measuring the effects of investor’s decisions to buy and sell investments. They have also studied the tendency for investors to switch in and out of specific mutual funds—in both short-term and long-term time frames.

And the results of these studies may surprise you. Dalbar consistently shows the average investor earns LESS … and in many cases MUCH LESS … than the mutual fund performance reports would suggest.

For instance—from 1985 to 2005 the S&P 500 averaged an annual return of 11.9%. But … the average investor … during the same period … made a paltry 3.7%!

To put his in perspective, $100,000 invested in the S&P 500 in 1985 would have grown to $947,549.00. But investors—on average—only managed to grow their accounts to $206,811.00.

Why ? …How could investors do so poorly during a period of great economic prosperity?

The answer is … Human Emotion! I know this seems like a simplistic answer. And it may require a bit more explanation. So let’s take a quick look at the emotional drivers killing investment returns.

Behavioral finance is a relatively new field seeking to combine conventional economics with behavioral and cognitive psychological theory. In short, it attempts to provide an explanation for why people make irrational financial decisions.

Have you ever made an irrational financial decision? If you’ve been investing or trading for any length of time … or even if your new to investing … the answer is likely “yes”.

And honestly, its likely a “yes” for all of us. But this is exactly where the value of behavioral finance can come into play and improve your investment returns.

Wall Street Is Out Of Touch With Reality

Economic theories such as the Capital Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) assume that investors are always rational and predictable. And most of the money being managed on Wall Street relies on this assumption.

But … real world evidence suggest that people act unpredictably and often irrationally. This is where we get the boom-bust cycles we’ve all experienced over the last 15 years or more. “Bubble” anyone?

There are volumes of psychological literature, documenting the systematic errors people make. How people think—has a significant effect on investment performance. Investors can be overconfident … or place too much weight on recent experience. Also, investor preferences can create distortions from reality … and the list goes on.

For example, people tend to underweight long-term averages. When equity returns have been high for years on end (like 1982-2000 in the U.S.), many people begin to believe high investment returns are “normal”.

Another example is in times of change. Generally, people tend to be slow in adapting to changing environments. More specifically, we tend to anchor on the way things have been and we ignore the new reality.

This is exactly what is happening today. There is a massive change underway … and a new reality is settling into the financial markets. Many of the old investment models no longer work and your emotions are not likely to help in this new investment climate.

This is where systematic investing can radically change investment results. By removing emotions, you can remove a large part of what hinders investment performance. Take the opportunity to look more into systematic investing at the Porfolio Café.

Also feel free to leave a comment or question below.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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