Note: This article is courtesy of Iris.xyz
By Pam Krueger
Individual investors are more empowered than ever before. Armed with online tools and mobile apps designed to educate and make even the most complicated investing decisions quick and easy, there’s never been a better time for those who want to optimize their portfolios. Empowerment, however, can be a double-edged sword: Study after study from sources like Morningstar and Dalbar show that when individual investors are left completely on their own, they dramatically and consistently underperform the broader market.
How much does a typical self-directed investor lag the overall stock market? According to Bloomberg, it varies, but it’s clear that the performance gap is real. Lou Harvey at Dalbar points out that when people think they can know the unknowable, they lose one-third to almost half the potential gains the market produced. His behavioral studies show that over a 20-year period ending last year, the overall return for the S&P 500 index was 8.19% a year; individual investors managed to earn just 4.2% a year.
Why Investors Leave Near Half Their Potential Gains on the Table
Two fundamental factors get in the way most often: emotions and transaction costs. In fact, one feeds right into the other.
The problem is that individual investors tend to react to every headline they read or hear instead of researching good investments, then sticking with them. Whatever has just happened most recently in the market tends to drive their next investment decision. Researchers at the University of California highlighted how this works through behaviors now referred to as the “disposition effect.” It’s an academic way of describing how when people react, rather than invest, they wind up losing money by dumping their winning investments and hanging onto their losers, and it’s not unlike gambling behavior.
Just how trigger-happy are self-directed investors? Credit Suisse estimated in April 2015 that the average U.S. stock was held for just 17 weeks. The annual turnover rate was 307%. It’s not just amateurs who try to outguess the market. Professional portfolio managers were also part of this same study, and it shows just how short-term the markets are looking. Pair this data with the studies showing that investors who trade the most earn the least (such as this one in The Journal of Finance), and you can see the problem clearly.