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Are You Your Own Worst Enemy When It Comes to Investing?

Investing is a path to financial independence and building wealth. Yet the reality for many individual investors paints a different picture. The DALBAR Quantitative Analysis of Investor Behaviour (QAIB) 2024 study sheds light on a troubling trend: the average investor consistently underperforms the broader market. The reason? Behavioural biases and emotional decision-making.

The Performance Gap

The report reveals that the average US share investor’s returns are significantly lower than those of the market indices. This year, equity fund investors underperformed the S&P 500 by a substantial margin, continuing a long-standing trend. This performance gap is largely due to poor market timing—investors often buy high and sell low, driven by reactions to market volatility and emotional responses to short-term market movements.

The Role of Behavioural Biases

Several behavioural biases contribute to this underperformance. Loss aversion, for instance, causes investors to fear losses more than they value gains, leading to panic selling during market downturns. Overconfidence can result in excessive trading as investors believe they can outsmart the market, despite evidence to the contrary. Herd behaviour, where investors follow the crowd rather than making independent decisions, also plays a significant role in poor investment outcomes.

Time in the Market not Timing the Market

The study highlights that retention rates— how long investors hold on to their investments—are crucial to achieving better returns. Frequent trading erodes returns through transaction costs and often results in missing out on market rebounds. The report indicates that investors who maintain their investment positions for longer periods generally see better performance compared to those who frequently buy and sell. This is illustrated in the chart above—investors who stayed in the market the full 10-year period were far better off even than those who only missed the best 10 days.

*2023 Value of an Adviser – Russell Investments

Performance by Investor Category

In the study quoted above, investors in the share markets were the most prone to underperformance compared to overall market returns. This underscores the difficulties individual investors face in effectively timing the market and managing their behavioural biases.

Reaction to Market Events

The report also examines how investors react to specific market events. Even in strong markets, such as in 2023, many investors failed to capitalise on the opportunities. Delaying investing can be as detrimental to investment returns as trading in and out of the market. This is one way professional advice adds value. Your adviser can provide you with comfort in your decision-making to enter the market and help you stay invested in times of volatility. If you have invested according to your own financial goals and risk tolerance, volatility can be understood as the price paid for greater returns, and not lead to premature selling.

Education and Awareness

The psychological aspects of investing are just as important as the practical aspects of investing, for example, portfolio structuring and tax. Financial advisers can play a critical role in helping investors understand these issues and stay committed to long-term investment plans, mitigating the negative effects of emotional decision-making.

Automated Investment Solutions

Automating your investment process is a potential solution to counteract behavioural biases. This can be in the form of creating a direct transfer every month into an investment account to attain goals set in conjunction with your adviser as part of an overarching investment plan.  By adhering to predetermined investment strategies, these automated solutions can help investors avoid common pitfalls associated with emotional trading.

 

Emphasising Long-Term Strategies

Investors are encouraged to focus on long-term investment strategies and maintain their positions through market cycles. The study consistently shows that those who stay invested fare better than those who frequently trade based on market movements. By adopting a long-term perspective, investors can avoid the detrimental effects of market timing and benefit from the overall growth of the market.

In conclusion, while market volatility is beyond an individual investor’s control, the response to volatility is not. By being aware of and managing behavioural biases, investors can significantly improve their investment outcomes.

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