While stocks are known to generate returns of around 7-10%, on average, over the long term, research shows that the average investor earns nothing like this.
For example, a recent study in the US by consultancy firm Dalbar found that, for the 30-year period to the end of 2016, the average equity fund investor earned a return of just 4% per year. In contrast, the S&P 500 index generated returns of around 10.2% per year over the same time period. That’s a significant underperformance. I have no doubt that UK statistics are similar and that many private investors underperform the FTSE 100.
So why does the average investor underperform the market and how can they achieve higher returns?
One of the main reasons the average investor dramatically underperforms the market is that investor behavior is often irrational. We all know the basics of successful investing, such as buying low and selling high, or holding onto investments for the long term. However, in reality, many investors fail to get the basics right because emotions get in the way.
All too often, when the stock market has gone up and investing feels easy, investors pile money into it (at the highs). Yet when the market drops and investing feels a little more difficult, they panic and sell out, and end up losing money. It’s this classic irrational behavior that results in many investors earning returns that are substantially less than historical stock market returns.
Fees and taxes
Another reason investors underperform is that they spend too much on fees and taxes. Investment fees (trading commissions, annual fees on funds, platform fees) and taxes (stamp study) often appear negligible at first glance. However, over the long term, they really can add up and subtract a few percentage points off overall returns.
This combination of irrational behavior and high fees is a toxic mix. With many investors buying and selling at the wrong time, and incurring significant fees in the process, they really stand no chance of beating the market.
So, what can investors do to boost their returns and avoid the fate of the average investor?
One of the easiest ways to generate higher returns is to invest with a long-term view. In the short term, stock markets will fluctuate. However, in the long term, they tend to rise. Therefore, the longer your investment horizon, the lower your chances of losing money and the higher your chances of making a good return. “Mutual fund investors who hold on to their investments have been more successful than those who try to time the market,” say experts at Dalbar.
Another way to boost long-term performance is by going against the herd. In other words, buying when others are selling and taking advantage of others’ irrational behaviour. In the words of Warren Buffett, it can pay to be “greedy when others are fearful.”
Finally, it’s important to keep fees low. This means investing through cost-effective products, such as ETFs, low-cost funds, or individual stocks, and not over-trading.
By doing these three things, you give yourself a good chance of generating excellent long-term returns and outperforming the average investor.
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