If I told you the annualized return over 20 years of the S&P 500 (an index of 500 large U.S. stocks) was 7.2%, what return would you guess the average investor experienced? Higher? The same? Lower?
It’s lower. Much lower. In fact, the average investor just barely beat inflation by achieving a meager 2.6% annualized return over 20 years.
A small part of this underperformance is due to trading costs and fund expenses, as these are not incurred in a benchmark index. However, the majority of the average investor’s underperformance is due to bad investment decisions.
The phrase “buy low, sell high” is very familiar, but there is quite a bit of evidence that the average investor does the opposite. During large market sell-offs, investors will often sell out of fear, rather than buy stocks at cheaper values. Additionally, average investors will “wait for the smoke to clear” and won’t re-enter the market until after it has already begun to recover. By then, the investor has already missed out on substantial gains.
In addition to bad timing, investors tend to get caught up in frenzies. The dot-com bubble and housing bubble are two such examples that had devastating consequences on the net worth of many families. Recently we have seen the same issues happen with cryptocurrencies and marijuana stocks. Often an investor is skeptical about such investments, but the fear of missing out kicks in when they see their friends making big investment gains.
It’s easy to look at past annualized returns of various asset classes and assume investing is easy, but as evident by the average investor performance, it is far from easy. In hindsight, investment decisions seem simple and obvious, but the future is neither. Because of this, it is critical that an investor keeps their emotions in check and follow a formulaic system of investing to avoid these behavioral pitfalls.
Alternatively, an individual can outsource those worries to a competent and fair financial advisor.