Equity investors getting below average returns

Equity investing is easy. It’s buying a mutual fund and holding it. The invested money grows at 15-20% compounding in line with what the fund has performed in the past. The investor will then happily retire wealthy. Except that is this is entirely false.

The truth - Investing is incredibly slow and requires a considerable deal of patience and discipline. The truth about investors is that they are lured by the equity markets to maximize or even multiply returns. Nobody wants to get rich slow. Everybody has heard about the power of compounding, but nobody has the patience for the power of compounding to kick in. It takes too long and requires the ability to do nothing in good and bad markets.

Let’s look at reasons why the average investor loses out on long-term wealth creation.

Return chasing behaviour

Today there are thousands of investment products in the market. The first mutual fund launched in the early 1990s, and since then complexity has exploded.

There are mutual funds, AIFs, PMS, REITs, ULIPS, structured products, ETF’s, International equity (recently people have started talking about small cases). Each category has hundreds (if not thousands) of choices. Also, there are hundreds of individual stocks, which can be bought and sold at the tip of the fingertips.

With so many options, investors tend to invest in the ones that have generated the most returns in the last 3-5 years.

There are hundreds of experts on twitter and television who have their livelihoods depend on customers reacting to good and bad news. Most people who chase returns, unfortunately, will get disappointed due to high expectations. Unfortunately, fund-level returns and investor level returns are usually off by a large margin.

Inconsistent risk profiles

Most financial advisors are required to document and assess the risk profiles of their customers before doing business or recommending investments. Investors tend to be aggressive during bull markets and conservative during bear markets, a classic example of greed and fear at play.

Aggressive investors in bull markets, as a result, will expose themselves to risky assets during bull markets and sell these risky assets at losses in bear markets as they are unable to bear the excessive risk.

The smart investor does the opposite - conservative in bull markets and aggressive in bear markets. Psychologically, this is difficult as this requires an investor to be conservative when the whole world (including your neighbours) are partying about their expertise in market timing and vice versa (taking bold bets when the world is grappling with fear).

Market timing

When an investor asks himself - “Is this the right time,” they are engaging in market timing. Another example of market timing is when an investor is waiting for the markets to correct (current mood of the market). Numerous studies have shown that market timing does not work and usually leads to more loss than profit for the investor. ‘Buy on dips’ and ‘average down’ are concepts sold by investment banks to get investors to trade frequently.

Globally, market timing is the prime reason for investors losing out or getting average outcomes.

FOMO (Fear of missing out) is the rationale for most bubbles and fear of losing more is the reason for investors selling their investments at losses.

The real numbers

A famous study done by Dalbar shows the actual performance of investors versus popular benchmarks (in this case, the S&P500). As of end 2018, over ten years - an average investor made 9.7% (S&P500 was 13.1%) and over 30 years; an average investor made 4.1% (S&P500 was 10%).

Over more extended periods - the reasons above contributed to even more mediocre results.

In conclusion, greed and fear are real, and investors need to ask themselves if greed and fear are causing them to make poor decisions.