By: Ryan P. Dolan
“You will do far better, in real-life, with an empathetic, tough-loving behavioral coach than you will on your own, or with some portfolio manager/sophisticate babbling about standard deviation when you’re having a panic attack in a bear market.”
Nick Murray
“The investor’s chief problem-and even his worst enemy-is likely to be himself.”
Ben Graham
An article in the New York Times, “Investor’s are Usually Wrong. I’m One of Them,” by Jeff Sommer, looks at the common, all-too-human behavioral foibles that constantly bedevil investors. “Forget about getting everything right. Most people are so consistently wrong that merely avoiding major errors is enough to set you apart from the pack,” states Sommers.
The article looks at data published by Dalbar, a research firm focused on investor behavior. Dalbar’s annual study highlights a consistent trend: equity investors earning far lower returns then the major stock indices. In 2018, for example, the average equity mutual fund stock investor lost 9.4% compared to a loss of 4.4% for the S&P 500. Over ten years, the average investor earned annual returns of 9.7% compared to 13.1% for the S&P 500.
As a caveat, there’s been some skepticism of Dalbar’s methodology and conclusions, which may exaggerate investor’s underperformance. While that is certainly possible, and the actual long-term results are impossible to quantify with precision, my experience and intuition leads me to believe that many individual investors do underperform by a considerable degree due to poor behavioral decision-making. These behavioral mistakes come in various shapes and sizes, but essentially boil down to investors consistently taking investment actions which, as Murray describes, “were the wrong thing to do, were done at the wrong time and for the wrong reasons.”
Take a 45 year old with $500,000 in his IRA today. Let’s say through consistent, modest behavioral mistakes his return over 20 years averages 6%, while the market returns 8%. The long-term impact? When he turns 65 and retires, those mistakes cost him over $700,000. Instead of $2.3m, he has $1.6m. With large compounded deleterious effects over time for even modest levels of underperformance, it behoves all investors to put a paramount focus on their behavior.
Nick Murray, a thought-leader in the financial planning industry, wrote “Behavioral Investment Counseling” in the midst of the financial crisis, a period which vividly illustrated the investing mistakes people consistently and repeatedly make. Murray contends, and I agree, that virtually no one is born a sound investor, and that behavioral mistakes are hard-wired into us. As such, in the quest toward improving long-term investment results for clients, the sound advisor should focus his investment efforts on trying to inculcate in clients a mentality and belief system which works to reduce, and hopefully eliminate these behaviors.
Murray’s solution? Focusing clients on the centrality and primacy of the financial plan, and relegating investing to the service of that plan. Most focus on investing and returns in a vacuum. It really doesn’t matter what your portfolio returned last year or next. What matters is whether you have a portfolio and process which gives you the highest odds of achieving your various long term goals. Only when you have a plan that works to address all of your long-term financial needs, priorities and goals, can you have a sense of what you need from your investments to achieve them. The investment portfolio, viewed in this context, is simply a tool in the service of reaching goals.
Often, when people put an excessive focus on investment performance, it stems from a disconnect in their financial plan (if they have one at all). Typically, those most focused on near-term relative performance aren’t saving enough and know that the only way to achieve their long-term goals is to earn unrealistically high investment returns. It is far easier to ratchet up your risk exposure, perhaps to improper levels, then to change your spending behavior today and begin to save more.
Once the financial plan is constructed, an advisor works to educate the client on how best to build (and maintain) an investment portfolio, which gives the highest likelihood of success.. Murray highlights several behavioral principles which need to be internalized in a goal-based, behavior-focused investment program, including:
Long-Term Optimism: “In the long-run, I believe that successful investing is essentially a battle that takes place in the investor’s unconscious mind-a battle between faith in the future and fear of the future.”
Patience: “Surely the most un-American of values. We live not in an age of enduring investment truths but of late-breaking market news, and this places the investor under constant pressure to do something-to react to the events of the moment rather than action on the goals of his lifetime and beyond.”
Discipline: “The undisciplined investor reacts-he allow his long-term investment plan to be derailed by some trend or event, and the plan inevitably fails. The disciplined investor continues to act, regardless of the terrors or enthusiasm of the season.”
The problem is we all know these market truisms. People also know, intellectually, the principles for losing weight, and yet cannot consistently implement them. The same in investing. Many simply cannot change their investment behaviors on their own. When the rubber hits the road, they cannot resist the markets frequent siren songs, compelling them to sabotage their long-term investing returns. Whether it’s getting caught up in investment euphoria, jumping into technology stocks in the late 1990s, or residential real estate in 2007, or giving into panic and despair in bear markets, discipline can be lost very quickly.
Take an objective, considered look at your investment behavior over time. Could you benefit from working with an advisor who can unpack your behavioral investment tendencies, and craft a battle plan to address them, all in the service of achieving your long-term financial plan and goals?