Investors have an addiction. Many of us feel like we can’t help it: we buy high and sell low even though it’s more logical to do the exact opposite. This addictive behavior is dooming us to a rocky investment experience and underperforming portfolios.
Last year, the S&P 500 gained a modest 1.38%. Dalbar found that the average investor actually suffered a 2.28% loss in their portfolio’s equity allocation during the same time period. Fixed income wasn’t the life preserver it should have been in this portfolio dynamic, either. While the Barclays Aggregate Bond Index stayed relatively flat with a gain of 0.55%, the average investor was down 3.11% in their bond investments.
But last year’s paltry average return rate wasn’t an anomaly.
Over the last 30 years, the S&P 500’s annualized return was 10.35%. Average equity fund returns for investors? 3.66%. In fixed income, the story is even worse. The Barclays Aggregate Bond Index returned 6.73% across 30 years. Investor returns in fixed income? 0.59%.
That means the average 60/40 investor took enough stock and bond risk to compound at 5.9% but only received 2.4% of the return.
Indices don’t take into account costs such as taxes and fees, but costs alone can’t explain this large of a gap between market performance and investor returns.
What can? An addiction to emotional decision-making.
Addictive behavior adds up
Volatility in the markets is causing investors to make decisions in a way that’s eating into performance. When investors added fixed income to their stock portfolios, they did so intending to reduce volatility and drawdowns to avoid making performance-destroying emotional decisions.
Investors anticipated the performance represented by the green line —a reflection of what the market is truly bearing. Instead investors are getting the yellow line, which Dalbar has shown is representative of average investor returns.
Emotions often win over economics
Two emotions are preventing investors from achieving that green line: greed and fear.
These emotional market forces are nothing new. Warren Buffet famously said “we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
People invest because they have money and want to make more—put simply, we’re greedy. Greed is a relative emotion, meaning some investors are greedier than others and different people with different risk tolerances will invest at different times. A retirement investor’s goals are different than those of a professional trader, even if both are looking for strong performance overall.
Fear, however, is an absolute emotion. It is driven by our fight or flight mechanism, which is designed to help us survive. When we feel fear, we want to get somewhere safe at any cost. Fear is often not a rational emotion. When markets drop and portfolios lose value quickly, investors will often sell in response to the volatility—even if it makes little economic sense for a retirement investor or a professional trader do so.
No wonder the average investor portfolio isn’t performing anywhere close to what it should be.
An investment intervention
How then, if investors are already diversified, can we reduce volatility in our portfolios and avoid the fear that prevents us from getting the returns we seek?
Here’s the investment intervention. The correlation of investors’ portfolios has been rising. Many of us have reached for yield to bonds beyond the U.S. treasuries that have provided strong diversification historically. This reach has lowered portfolio diversification and created the current “risk on/risk of” environment. In this environment, it is much easier to get swept up in volatility and make emotional decisions.
To detox from this addiction to emotional investing, investors can transform their portfolio with a new source of diversification—one that accesses a different type of risk. Investors can accomplish this by allocating to uncorrelated assets.
Those of us looking to go beyond a short-term fix should seek assets that historically can do what diversifiers are supposed to do best: provide low correlation in declining market conditions while also achieving a real rate of return.