What is the biggest mistake the average investor makes?

Welcome to Finance and Fury.

In this episode – we will be looking at the most important mistake to avoid when it comes to investing – and that is chasing returns

1. This is where, in some instances, following the trend doesn’t work – as we will go through, in many cases the average investor buys an investment after a positive return or alternately, fails to hold on to an investment after a period of a negative return
2. Most of this decision is based on emotions – both in the positive and negative context – so this is what we will be breaking down further in this episode

Timing for investments can be everything – and that is the best thing you can do is to not try and time the market at all but stay in the game

1. This isn’t about trying to get in at the bottom or out at the top – but controlling investment behaviours
2. Investors on average, are so bad at timing entries and exits into markets, that they can still lose money even if they are invested in a constantly winning investment
3. This is all done by buying after periods of good performance and selling after periods of bad performance –
4. This can feel instinctive – but is generally wrong –
   1. This is evident when looking at Fund flows – which measures the volume of investments
   2. Looking at some major Investments – when markets are going up, you generally see the biggest inflows of capital, but after they have declined, you then also see the largest levels of withdrawals
      1. This is partially true with Index funds, as the flow of capital across the whole index generally indicates the direction of the market
   3. But where this gets worse is smaller capitalisation investments or ETFs or Managed Fund that have stakes in certain companies – as these forms of drawdowns get worse for more volatile funds or investments – just look at the flows in and out of BTC
5. This pattern is true with most investments that have had long term positive returns – the volume of money points to that most investors may have had negative experiences in these investments – even if the investment has had long term positive returns

These sort of results all comes down to behaviours 

1. The alure of positive returns can create what’s known as dumb money – where people enter the market at the wrong time – but also exit the market at the wrong time
   1. Any financial market is a process of buyers and sellers coming together to determine the price that any asset is sold at – the more liquid the quicker this process occurs –
      1. If you have investors who are looking to get out of an asset – i.e. they want to sell – this then means that they need someone on the other end of the trade to be willing to buy at or around the price that the wish to sell at
      2. This is where this dynamic can become complicated – because what if nobody wants to buy at the price you wish to sell – instead they may wish to buy at a lower price – therefore, you need to come down in your price expectations to sell your asset – but don’t wait too long, otherwise other sellers may beat you too it and the buyers at that price point may be accommodated and you will need to further lower your price to meet the next rung of buyers
   2. When investors are willing to sell on mass at a major loss – this is considered to be “Money to the market” – as those buyers on the other end of the trade can end up in a better position long term
      1. This is obviously asset dependent – as certain investments may never recover from their price declines – I certainly have owned one or two of these types of investment where it would have been better to get out after the first 10% decline in their price – but looking back on a 15 track record – this includes 4 investments in total – this doesn’t mean that I have only had declines on 4 investments – as almost all of my investments I have experienced negative returns on in short periods of time
      2. What I am talking about is that over 15 years, only 4 are still negative – whilst 54 that I still hold are positive

• For a few of these that were down 40% from their initial purchase price, some of these are now up by 300% or more – If I had sold these certain investments, then I would have lost 40% and never seen the recovery

Looking at the Dalbar studies – Dalbar’s founder Lou Harvey does quantitative analysis on investments based around behaviours of investors

1. The most recent release of his study found that – Buy-and-hold investors in equity index funds, equity value funds and real estate sector funds earned the highest average returns in 2021
   1. Again, these returns reflect the behaviour of the average investor – Based on this behaviour, the analysis calculates the “average investor return” for various periods. These results are then compared to the returns of respective indices.
2. The average equity fund investor:
   1. Was a net withdrawer of assets in 2021 for the sixth consecutive year – showing that investors withdrew more money than they invested – 6 years running
   2. Finished the year with a return of 18.39% versus an S&P 500 return of 28.71%; an investor return gap of 1,032 basis points (bps)—the third largest annual gap since 1985
   3. Average investor would have earned $17, 950 in 2021 on a portfolio with a balance of $100,000 – compared to a buy-and-hold strategy of $100,000 in the same funds would have earned $28,705.
   4. This comes form the average investor having retention rates averaging 4.36 years by 2021.

The sad truth is that the average investor is usually wrong when it comes to entering and existing the market – and being focused on the short term over the long term benefits of equity ownership – this can occur from trying to avoid further perceived errors to get outperformance – or from trying to chase the currently best returning asset/investment

3. Breaking down this behaviour – the average investor buys after a price rise and fails to stay invested in any given fund to see the benefits of asset ownership
4. This conclusion comes from looking at the Dalbar studying the behaviour of mutual fund investors for 25 years
5. The Dalbar data leads to the inescapable conclusion that most investors panic and exit the market at the wrong moments
   1. What’s shocking is that simply by investing, the average investor has actually made themselves poorer in recent years
   2. The Dalbar results for 2018 are especially painful to contemplate. The inflation rate was 1.93 percent, so investors would have had to earn that just to tread water. Instead, the average fund investor lost 9.42% percent – for a gap of more than 11% to a buy and hold strategy
6. The average individual when it comes to actively trying to enter and exit the market compared to just holding the S&P 500, through Dec. 31, they underperformed by:
   5. 88% annualized, over 30 years; 3.46% annualized, over 10 years; 4.35% annualized over five years.
   6. Trying to guess what is going to happen and invest or sell at a significant market time tends to lead to the worst results – it also shows that real returns materialised in the long term by just holding
7. Keep it simple stupid – and only use money that you can afford to tie up for years
   1. If you are going to need money soon, to finance a short-term expenditure or as a deposit to buy a house, you shouldn’t take risks with it – and retain this in cash
   2. But any funds that you don’t need – in other words, long term money – this can stay invested in the market – don’t try and be fancy – just keep it invested in high quality assets
   3. This does require a high degree of discipline – essentially consider your invested funds off limit – avoid giving into temptation and redeeming any of these funds
8. As a comparison on this ‘off limits’ strategy – in the US there are products known as variable annuities – which is a blend of managed fund and insurance product that you cannot touch for a period of time –
   1. Investors in these annuities outperformed those who bought the equivalent managed funds personally, even though the annuities had much higher fees
   2. This is because these annuities generally impose “surrender charges” that investors must pay if they want to sell their funds before a set period of normally 10 years – meaning that the money is effectively locked away
   3. Yet despite the extra fees and penalties — perversely, it seems, because of them — investors in variable annuities outperformed those in mutual funds over 12 months, as well as over three, five, 10, 15 and 19 years, Dalbar found.
   4. The secret to the annuities’ success appears to be the fact that the money invested in these products is locked away – so this isn’t an endorsement of variable annuities – but simply the discipline they impose is what makes this product successful over trying to exist the market at the wrong time

Chasing investment returns is one of the worst long term strategies for wealth accumulation – we all are after returns, but there is a difference between investing for long term returns and trying to chase a return by switching investments every year or two to try and cash in on the best performing asset –

1. Any search for the top performing investment will likely yield a specific sector investment fund – This can range from sectors like health care, financials, technology, materials or industrials, etc.
   1. This is because there will always be one sector of the share market that outperforms the broad market – Even though this sector is part of the market ,other sectors can be declining within the broad market, resulting in an aggregate return
   2. As an example, let’s look at the ASX
      1. Energy over the past 12 months is up 45% which is a great 1 year return – but what is the total return over the past 10 years – 1.5% p.a. when annualised over 10 years
      2. On the other hand – Technology is down 33% over the past 12 months – But the annualised 10 year returns are 13.9% p.a.
   3. So as an example – selling technology shares now after the price declines and buying energy shares could likely result in a loss over the next 10 years
2. This is where it is generally a mistake to invest in the last years best performing sector – as expecting annualised returns of 30% within most investments isn’t achievable – therefore, after a period of higher-than-average returns, the market tends to normalise through providing lower than average returns
3. This is where another insight is that the periods of highest returns from certain sectors come after periods over lowest returns
   1. To avoid the mistake of buying into the best performing asset – it helps to expand on the focus on investment behaviour – We all want to be part of the winning crowd – Nobody wants to invest in a losing sector – This isn’t necessarily true for individual shares but sectors at large – people tend to offload investments when the lose money
   2. But we have no real capacity to know the exact future – Some people are able to predict the market – but a broken clock is right twice a day

In summary –

1. Long term buy and hold strategies have yielded the best returns for investors when compared to what is considered the average investor –
2. Through chasing returns in specific sectors – investors often are buying in at the peak of the market and then after seeing a period of market normalising where this best performing sector starts to see declines, they sell in fear of worse negative results
3. This is obviously asset dependent – as you could buy a tiny mining company that is starting to lose funds due to bad company specific news and it may be best to get out of this company before it goes to nil –
   1. However – the type of investments we are talking about here are diversified funds that are invested in generally higher quality investments
4. Therefore – the data points to long term ownership of capital being the best strategy – and not selling investments after a market loss has occurred or on the other end, buying into an asset sector that has seen significant returns over the past one to two years – as historically a negative period soon follows this pattern