Unmistakably, market drops reinforce anxiety for investors. You may feel the impulse to take action when markets are roiling, but we believe the worst thing investors can do during times of stress is deviate from a long-term investment plan.
Studies have shown that people are their own worst enemies when it comes to investing. Dalbar, a market research firm focused on investor behavior, found that from 1985-2014, investors only captured 52% of the return of the broad U.S. stock market. In annual percentage terms, investors underperformed the S&P 500 by more than 4.5% over a 20 year period. Said another way, the average investor who invested $1 million at the beginning of 1985 left $2.4 million on the table over 20 years!
Behavioral finance is a field of study that combines behavioral and psychological theory with economics and finance to explain why investors act irrationally.
Here are five of the more prominent behavioral traits that can harm investors:
1. Loss aversion helps explain why investors sell an investment at the wrong time or why so many investors are still in cash after the 2008 stock market crash. When investing their money, investors often focus on what can go wrong rather than the potential gains.
2. Mental accounting is investors’ tendency to separate their money into different buckets based on insignificant criteria such as its source or where it is managed. Many investors allow several financial advisors to manage their assets, believing that doing so reduces risk. In reality, not looking at one’s assets in aggregate can result in unintended consequences that may prevent an investor from meeting his or her financial goals.
3. Availability bias helps explain why investors are fearful to invest after a market decline, despite the fact that markets tend to rise more often than they fall. People tend to more readily recall and subsequently heavily weight their decisions on the most recent information available to them.
4. Herd behavior is the tendency of investors to follow the crowd, or mimic other investors’ behavior. Investors are often tempted to sell investments and hold cash when others are panicking, even though there may be no rational reason to do so.
5. Overconfidence can lead to trading too often, as investors believe they can accurately time when markets will rise and fall. Trading chips away at returns over time, contributing to investors’ underperformance.
Because these pitfalls have been identified, checks can be put in place so that they do not derail investment decisions. Revolution Partners develops an investment plan for each of our clients at the onset of the relationship and offers tools for investors to aggregate their accounts so that we can look at the total portfolio when making investment recommendations.
We consider multiple factors when building and adjusting portfolios, including our capital markets expectations, investment fundamentals and the macro environment. We invest in strategies that we have fully vetted and that we trust will perform well over time, especially during periods of excess market volatility. With our process in place, we avoid the temptation to deviate in response to short-term market fluctuations.
Above all, please keep in mind that if equity markets didn’t appreciate over time, they wouldn’t exist at all – no one would participate. In the meantime, one’s temperament is as important as having a solid financial plan. Strength in both is a powerful combination to achieve long-term investment success.