In the ten years from 2016-2025, the S&P 500 returned 9.9% annually, yet the average dollar invested in US mutual funds and exchange-traded funds earned only 8.7% annually (see chart below).
Another study by research firm Dalbar showed that over a 30-year period ending on 12/31/2021, the average equity fund investor earned 7.13% annually versus 10.65% for the S&P 500 (source: https://lanningfinancial.com/why-the-average-investor-underperforms-the-market/).
Why does this happen?
Because Investors Tend to Make Poor Decisions.
The gap between market returns and average investor returns is known as the “behavior gap,” and most investors are susceptible to it.
People repeatedly make emotionally driven decisions. The costs seem small in the moment, but over decades they can significantly reduce wealth creation.
But Not Me!
Of course, none of us think we are prone to making behavioral investing mistakes.
Just as 80% of drivers believe they are above average, we all believe we make sober, rational investment decisions. It is just the “other people” who make poor decisions, right?
We humans have an amazing ability to deceive ourselves, and these emotionally driven actions are causing millions of financial plans to miss their potential.
I’m fascinated (and saddened) by stories of investors destroying their financial plan due to one or two avoidable mistakes.
And I’ve made it my life’s mission to make sure that does not happen to the select families God has entrusted me to serve.
Our Biases
With that in mind, let’s review four of the most common biases and the mistakes they create.
Recency Bias (Performance Chasing)
It’s human nature to think that whatever has happened most recently will continue indefinitely.
Imagine you are a prospective client meeting with me on New Year’s Day, 2000. We (apparently) survived Y2K, and we are both excited for the investment possibilities ahead of us. As we sit down, I show you the chart below, which illustrates the S&P 500 compounding at 15.3% annualized from 1990 to 2000.
Source: Koyfin
Based on the chart above, would you guess the next ten years would be up or down?
Because of recency bias, investors became complacent around the turn of the century, bidding up valuations and completely sidestepping fundamentals and risk.
The next 2.5 years were not kind to shareholders, with the S&P experiencing a 47.1% drop in value. From January 2000 to October 2002, $1,000,000 became $530,000.
The Great Recession
Five years after the 2002 bottom, the market was in freefall once again, dropping 56% from October 2007 to March 2009 (see chart below).
Source: Koyfin
Those who believed “what happened in the recent past will continue” moved to cash, while other investors who stayed in stocks (S&P 500) have compounded at 14.9% per year for the last 17 years (source: Koyfin).
When markets are riding high, our brains tell us, “This is a new era… there is unprecedented opportunity”… so we decide to pile into the shiny object du jour.
When markets are in free-fall, we convince ourselves, “This time is different… I don’t want to catch a falling knife.”
The bottom line: we tend to overweight recent events, and underweight long-term history.
Prospect Theory (Loss Aversion)
It’s been found that investment losses are felt roughly twice as intensely as comparable gains. For example, if I gain $100,000, it feels good. If I lose $100,000, it feels terrible.
The losses hurt more than the gains feel good.
This helps explain why behavioral investing mistakes are most common during bear markets. When markets are up 20%+ three years in a row, investors still succumb to FOMO and chase shiny objects to some degree.
But when a bear market occurs, it is easy for otherwise very rational investors to make catastrophic mistakes. Why? Prospect theory tells us it’s because of the intense pain the investor is feeling from the paper loss.
Herd Bias
In 2000, it felt reckless to not own small internet stocks.
In 2006, the narrative was that national home prices never go down.
In 2020, it seemed obvious that people were no longer going to travel the way they once did, and therefore “stay-at-home” stocks were a sure thing.
Clearly, the “herd” is often wrong.
As the famed investor Sir John Templeton mused, “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.”
Self-Deception
“The heart is deceitful above all things, and desperately sick; who can understand it?” Jeremiah 17:9
Most people know intuitively that market timing doesn’t work. Every client I’ve interacted with has acknowledged this. But humans are funny creatures – we can agree intellectually with something, and one minute later contradict that with our behavior.
Advisor: “You understand market timing is impossible?”
Client: “Yes, absolutely.”
Advisor: “Wonderful.”
Client: “Hey, so I’ve been wanting to get your take on putting our portfolio on the sidelines for a few months. With the uncertainty surrounding the midterms, valuations are kind of high… oh, and my neighbor just lost his job… I’d like to get back in once things have settled down.”
We have a remarkable ability to convince ourselves of things that aren’t true, especially when we desperately want them to be true (things like “I can outguess the market.”)
This self-deception is like carbon monoxide: it permeates the air around us, goes unnoticed, and can become fatal.
The Playbook
So, if we have biases and they hurt our investment returns, what do we do about it?
- Understand your tendencies
What is your game film? What do you tend to do when the market is rocky, and fear is high? What about when stocks are soaring, and euphoria is everywhere? The best predictor of future behavior is our past behavior, whether we like it or not. In two words: “know thyself.”
- Root yourself in an investment philosophy and strategy that puts a lid on emotional decision-making
Understanding our biases helps, but we also must root ourselves in an investment philosophy and strategy that allows us to stick with it through the ups and downs.
While every advisor may have their own take on which investment strategy is best, I’ve found that Dividend Growth investing is unique in that it combats detrimental investor behavior.
Dividend growth* mitigates recency bias because investors become focused on questions like “is this business generating cash flow?” and “can this company grow its dividend”? Focusing on these enduring prospects of a business is fundamentally different than hoping and praying that recent momentum will continue.
Dividend growth combats prospect theory / loss aversion because instead of obsessing over volatility and price declines, the measurement of success shifts from portfolio value to direction of income. Experiencing a portfolio decline of 20% hurts, but seeing your paycheck (dividends) rise in the midst of volatility helps investors weather the inevitable storm.
This approach avoids herd bias because, well, dividend growth investing is not sexy. It is not as fun to talk about a consistent, rising dividend as it is to talk about how your neighbor’s sister-in-law bought her oceanfront property with a triple-leveraged option ETF.
Ultimately, this investment philosophy enables investors to hang on even in the most fearful of times because it is rooted in a simple premise (human beings produce goods and services that meet the needs of humanity, leading to profits, which eventually get passed along to investors in the form of a dividend). Knowing what you own and why you own it is critical, as it makes it easier to stay rooted in a consistent strategy.
- Hire a Professional
I could create a New Year’s Resolution and tell myself that I’m going to work out more this next year, but there is nothing stopping me from being lazy. There is no buy-in, no accountability.
If I hire a personal trainer, however, I am now accountable to someone. The trainer, in turn, has a sense of ownership over my fitness. If I get lazy, he has both the incentive and responsibility to hold me accountable.
Advisors help with asset allocation, tax planning, estate planning, business transition, insurance planning, and many other topics. But studies consistently show that investors who work with an advisor avoid many of the behavioral mistakes DIY investors make.
As advisors, it is our moral and professional duty to protect clients from making poor (and sometimes catastrophic) financial decisions.
Never Interrupt Compounding Unnecessarily
What do you think, dear reader? Are you exempt from emotional biases like the rest of us? Are you an above-average driver?
Does your portfolio hold some extra cash because you are waiting for the right entry timing? Are you having a hard time parting with a concentrated position because it’s done well for you in the past?
Most financial plans do not fail because of the Fed or because we entered a bear market. Financial plans most often fail because an investor fell prey to their own emotions. They fell in love with the darling stock of the day, fear gripped them when the market dropped 10%, or they were convinced they knew something the market didn’t.
Plans fail because strategies are abandoned at exactly the wrong time. We see it all the time.
That’s why we’ve made it our mission in life to come alongside clients to be a source of truth, guidance, and in some cases, tough love.
The most successful investors are the ones who stay the course when others abandon the plan.
*If you’d like a copy of our white paper, “The Power of Dividend Investing” let us know and we can send you a PDF.
Trevor Cummings
PWA Group Director, Partner
