How Investor Behavior Impacts Returns
When people think about investing there are a few common topics that come to mind: diversification, valuation, interest rates, and growth rates to name a few. While these are all important, we believe the key factor with the greatest impact on long term outcomes, is investor behavior. When we refer to behavior as it relates to investing, we mean how investors react during various market cycles. While the investment industry has started to embrace “Behavioral Finance,” we still think there is more that can be done. 1 As an example, the most common investment approach amongst financial advisors is “Buy and Hold.” Using this approach, the financial advisor helps an investor select an asset allocation, makes slight modifications over time, but primarily recommends investors ‘stay the course.’ We are not suggesting that this strategy isn’t fairly effective in theory, however, in reality investors tend to capitulate when the market suffers a correction; so, the question is not so much about the effectiveness of the strategy, but an investors ability to follow it.
The chart below illustrates the reality of investor behavior during periods of market corrections. Since 1993, the 5 worst months of outflows from Long Term Funds (ETF’s and Mutual Funds excluding Money Market Funds) came during major drawdowns in the market. Based on this, we would suggest that buy and hold works until investors experience significant volatility.
Buy and Hold Works Until It Does Not
Historically Investors tend to buy and sell based on the recent performance of the market
Source) ETF Flows: Morningstar, US ETFs, Include Obsolete Funds, Mutual Fund Flows: ICI.org, Domestic Equity, S&P 500 Total Return Index: YCharts, 1/1/2007 – 10/31/20
Past performance is not indicative of future returns.
During severe market corrections, many investors face challenges that can materially impact their long-term financial plans. These challenges can result from investors fearing the worst, experiencing severe anxiety, and then reacting to those fears. The feeling of ‘wanting to get out’ while the market is going down can overwhelm them and can cause them to buy and sell at the wrong times. Research shows that the average investor significantly trails the returns of the market over time (see below). We would suggest that much of this has to do with investor behavior as opposed to choosing the wrong allocation, Mutual Fund or ETF.
The Average Investor Does Not Stay the Course
The results reflect that the Average Investor Significantly Lags the Market
Source: 2018 DALBAR QAIB Report, 1/1/1988 to 12/31/2017
From the above chart we see the average investor generated an annual return of 3.88% vs. the market’s return of 5.62% over the past 20 years. We believe this 1.74% underperformance annually over 20 years is a direct result of investor behavior. The question is not how the market performed over the last 10 or 20 years, but rather, how did the investor perform?
Advisors are increasingly utilizing Behavioral Finance in an effort to interact with their clients more effectively. According to the article, “The Evolving Role of Behavioral Finance in 2020,” financial advisors highlighted the benefits of incorporating Behavioral Finance into their practice. In fact, 55% of advisors reported the benefit of keeping clients invested during market volatility in 2020 vs. only 30% of advisors reporting this as a major benefit in 2019.2 We conclude that while advisors have historically focused on portfolio management and customer service, they are now recognizing the importance of, and challenges to, helping their clients stay the course during turbulent times.
Because of this, Blue Square Wealth has incorporated Behavioral Finance into the construction of our investment strategies. We manage portfolios that aim to reduce portfolio volatility over full market cycles because we believe that investors continue to react impulsively, often to the detriment of their own investment goals.
Please see below for a recent video discussing the emotional effects of market volatility featuring Herman Brodie, a highly regarded expert in behavioral finance and a member of our advisory board.
About Blue Square
At Blue Square, rather than trying to predict the future, we aim to prepare for it, regardless of its direction. Using our proprietary technology and rules-based approach to investing, our decisions are not swayed by predictions or emotions.
Our investment strategy focuses on Risk Management by positioning portfolios defensively during significant market declines. By systematically raising cash during these periods and reinvesting that cash once markets are more accommodating, we look to create a less volatile investment experience, and ultimately deliver better risk-adjusted returns over full market cycles.
1) Behavioral finance is a sub-field of behavioral economics, proposes that psychological influences and biases affect the financial behaviors of investors and financial practitioners. Source: Investopedia
2) Source: Investments and Wealth Research, The Evolving Role of Behavioral Finance in 2020, Scott Smith, Issue 3 2020
Blue Square Wealth is a SEC-Registered Investment Adviser. A copy of the Firm’s Current Disclosure Brochures can be found on the SEC’s IAPD site or may be requested at any time by contacting us. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Securities and Exchange Commission.
All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client’s investment portfolio. Past performance is not indicative of future returns.
Significant risk may accompany investments in stocks, bonds or other asset classes over short periods of time. Investment return and principal value will fluctuate with changes in market conditions. Your investment may be worth more or less than your original cost. Past performance is not indicative of future results.
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