There have been a number of studies that highlight how a retail do-it-yourself (DIY) investor consistently underperforms the market. Many have taken to managing their own portfolios either because of a bad experience with a previous money manager, mistrust of ‘financial advisors’, a confusing term often associated with an insurance salesman, mutual fund salesman, annuity salesman, money manager, financial planner, portfolio manager, etc. Or they may feel they are smart enough AND have enough time on their hands to manager their own money better than anyone else could. The data confirms that they can’t!
One of the most well-known studies on investor behavior andperformance is conducted by Dalbar in theirQualitative Analysis of Investor Behavior, which is completed annually.Dalbar uses data from the Investment Company Institute, Standard & Poors, BloombergBarclays Indices, and proprietary sources to compare mutual fund investorreturns to an appropriate set of benchmarks. The ‘average investor’ is definedby the behavior evident in mutual fund sales, redemptions, and exchanges. Itdoes not apply to investors that buy individual securities as this activitywould be much harder to measure – although I suspect it would be similar, ifnot worse.
The chart below shows retail DIY investor performance relative to the S&P 500. It doesn’t matter what period we analyze, the results are the same – average investors have underperformed a buy and hold S&P 500 strategy – sometimes by a considerable margin. So much for not wanting to pay an advisor a fee for their services. With an annualized underperformance of more than 5%, some average investors are better off being less active – or hiring an advisor.
There could be many reasons why the average retail investorunderperforms a simple buy-and-hold strategy,y but I will focus on just a fewthat I come across with uncomfortable regularity.
DIY Investor Psychology
Many DIY investors have a problem with timing. The problem is they think they are great market timers. Instead of buying low and selling high, however, they end up selling low and buying high. The process usually looks like this: The market starts declining and investors hold on to their positions thinking they would sell once the market recovers. (Selling a losing position will be like admitting defeat) As the market continues to decline, a panic starts to set in and the media paints a picture of a terrifying situation. As some investors start to sell (most institutional investors already sold), prices continue their downward trend causing more panic and eventually leading to even the staunchest of investors to sell – at the bottom.
Then, the institutional money realizes we’ve reachedcapitulation and figures out that even if the market may not be at rock-bottom,it’s cheap enough that it can start buying in again. Meanwhile, retailinvestors are licking their wounds, avoiding their brokerage statements, andstill listening to ‘bad’ news not realizing that the bad news is now old news. Institutionalmoney, however, is figuring out what is going to happen in the future, and althoughtheir crystal ball is no better than anyone else’s, they realize that thingsare getting better, and that it will eventually cause stock prices to recover.By the time the retail investor starts investing again, however, they’ve misseda considerable recovery in the market.
All or Nothing
The other factor that contributes to DIY investor underperformance can be captured by the often stated ‘getting in or out of the market’ comment, which implies that many investors are either completely invested or completely in cash at any given moment in time. This is an oversimplification but again implies that the average investor can figure out the exact moment when they should be getting in and getting out of the market. A more prudent strategy would be to gradually increase investments as the climate becomes benign and opportunities are presented, while gradually decreasing exposure as risks rise or the economic climate gets murky.
I like to compare managing a portfolio to driving on a longroad trip. When the weather is clear and there is little traffic, we can speedup and drive a bit faster than we otherwise might. But a light rain may causeus to slow down a bit and be more cautious, while a torrential downpour might leadto even further reducing our speed. Add a bit of traffic (noise, risk, etc.)and you might slow down even further. But only if the storm is bad enough toreduce visibility to zero do we consider completely pulling over to the side ofthe road. Yet when it comes to investing, we move to the side of the road toooften. This is what average investors do when they decide to reduce risk – theypull out of the market instead of just slowing down by reducing some exposureor adjusting their positions.
Lack of Strategy
As an investment strategist and portfolio analyst, I’ve seena number of portfolios that are a collection of great individual ideas but thatdo not have a coherent strategy. It would be comparable to having a pantry fullof tasty ingredients, together which would not make anything taste remotely edible.Proper money management starts with developing a strategy for how you shouldmanage your portfolio – a recipe of sorts. Will you be aggressive orconservative? Are you seeking income or growth? How much risk are you willingand able to take? What is the time horizon you are considering for theseinvestments? All of these factors and more will dictate how your portfolioshould be managed and what specific positions you should be investing in and inwhat amounts. Just like you need to know what you are cooking in order tofigure out which ingredients you will need and how much you will need of each.
Lack of Process
The lack of an investment strategy typically means there isno defined investment process in place either. An investment process iscritical for money managers to measure and optimize their performance. When I’mconducting due diligence on a money manager, performance is important, but Ispend more time analyzing their process. Performance can be luck unless it isrepeatable and it’s the process that makes performance repeatable.
A process might include some or all of the followingcriteria:
- The universe of investments being considered(i.e. small cap growth stocks)
- The framework for analyzing a potentialinvestment
- The criteria that each investment must meet(i.e. revenue growth, increasing margins, market share %, etc.)
- A timeline for reviewing and updating currentholdings
- Analysis of how the holdings in the portfoliointeract with each other
- Factors determining position size and process ofincreasing or decreasing positions
- Limitations on position size
- Limitations on sector or industry exposure
- Criteria for selling a position
All professional money managers likely have a disciplined process in place that guides their decision-making. The process can be adapted and improved as needed but the important thing is that there is a process in place. A DIY investor, on the other hand, is likely to not have a process at all. They are more likely to have a collection of individual ideas and no way to explain how they came together or why they are still in the portfolio.
Lack of Discipline
Even investors that have outlined their investment strategyand formalized an investment process oftentimes fall short when it comes tomaintaining discipline. Too often exceptions are made because ‘this situationis different’ or an idea came from a successful investor friend. One exceptionmight be OK, but if they become the norm, either the process is irrelevant orneeds to be adjusted to reflect relevant investment criteria. It’s OK to adjusta process as needed to make it better, but when exceptions rule,underperformance will certainly follow. For example, if an investor has a rulenot to invest in companies with a PE ratio above 24, a company with a PE ratioof 24.1 does NOT qualify. It should not be included in the portfolio. If it is,and these exceptions become the norm, then the investor needs to considerchanging that criteria.
Concentration
By investing in a well-diversified index fund like SPY, aninvestor has diversification across 500 stocks. If any one goes to zero(possible but unlikely), it would result in a loss of just $2,000 on a $1Mportfolio. But most investors might be concentrated in just 25-30 individualstocks. This is a reasonable number in that an individual investor probablycan’t adequately follow more than this number of stocks – but it is still notadequate diversification in some cases. If one of these stocks goes to zero, theloss is $40,000!!
Conclusion
If professional money managers can’t outperform an indexover long periods of time, why would a retail investor, even an extremelyintelligent one, outperform? They wouldn’t. Combine several behavioral biasesthat retail investors are unaware of, a lack of strategy and process, a lack ofdiscipline, and poor portfolio management that results in too much concentrationor knee-jerk reactions, then the only thing left for an investor to rely on foroutperformance is luck.
Can it happen? Yes, just like you can go to Vegas for a weekend and leave a winner. But go back on several occasions thinking you will have the same results and you might lose your shirt, or worse, your retirement dreams. After all, where do you think the money to build those beautiful hotels came from? If you want to gamble, go to Vegas, but if you are going to join the ranks of DIY investors learn the proper way to manage your portfolio, not just randomly pick stocks – or find yourself a trustworthy advisor. They might not always be right, but at least they will be objective.
