Economics and finance traditionally assumed that humans were perfectly rational in their decision-making. In fact, many of the major economic and financial theories developed in these fields were based on this important assumption. Among other things, perfect rationality implies that humans are always able to maximize their economic utility and are not subject to psychological biases. In the real world, however, the assumption of perfect rationality clearly does not always hold true. In certain situations and under certain conditions, humans can and do fail to act rationally, sometimes in predictable ways.
In recent decades, it has become more widely accepted that psychology and human emotions play a much larger role in economic behavior than was traditionally acknowledged. A relatively new field of economics called behavioral finance has emerged which attempts to understand and explain how human psychology impacts financial decision-making. One of the main topics of study in behavioral finance is how people make investment decisions.
Investor behavior is a critical, yet often underappreciated, factor in explaining the poor historical investment returns of individual investors. Many studies show that the investment returns of individual investors lag those of the broader markets. High investment costs are often cited as the main reason for why so many individual investors achieve poor investment results. However, as it turns out, investor behavior is arguably much more important.
A financial services market research firm by the name of DALBAR, Inc. publishes an annual study that looks at the impact of investor behavior on investment returns(1). Specifically, the DALBAR study examines the returns that individual investors generate by investing in mutual funds and how those returns compare to the returns of the broader equity market.
DALBAR has conducted its study since 1994 and has consistently found that the returns of average investors significantly lag those of the broader equity market. For example, for the 20-year period ending December 2015, the average equity mutual fund investor in the DALBAR study underperformed the S&P 500 stock index by an average of 352 basis points, or 3.52%, per year(2). Unfortunately for individual investors, the results from this 20-year period are not an outlier. In fact, individual investors did considerably worse over the 30-year period ending December 2015(3). The extent to which the average equity mutual fund investor in the DALBAR study has underperformed the broader equity market over long periods of time is disconcerting.
Perhaps the most interesting aspect of the DALBAR study is that it goes beyond the headline numbers to analyze the specific causes of equity investor underperformance. The following table summarizes the findings for the 20-year period ending December 2015. The data makes clear that while there are several major reasons why individual equity investors underperform, investor behavior is by far the single most important explanation.