Updated: Feb 15, 2022
When it comes to money and investing, we're not always as rational as we think we are.
How has been the performance of retail investors? What does research say?
In 2001, Dalbar, a financial-services research firm, released a study entitled "Quantitative Analysis of Investor Behavior," which concluded that average investors consistently fail to achieve returns that beat or even match the broader market indices. The study found that in the 17-year period to December 2000, the S&P 500 returned an average of 16% per year, while the typical equity investor achieved only 5% for the same period—a startling 9% difference!
In 2020, the average equity investor continued to underperform S&P 500 by 1.1%. During the first 6 months of 2021, the equity investor underperformance gap ballooned by 100 basis points to 2.1%. This does not include any transaction related costs or any taxes especially short-term capital gains tax.
Research confirms our gut feeling that equity investor do underperform the broader markets. We have seen this movie playing out before – dotcom crash of 2000 or global financial crisis in 2007-08.
Why does this happen?
Behavioral finance is an area of study focused on how psychological influences can affect market outcomes. One of the key aspects of behavioral finance studies is the influence of psychological biases. Based on the extensive research carried out using behavioral finance, researchers have provided the following reasons for individual investors underperformance:
1. Asymmetric information – Institutional investors have better access to information. When faced with liquidity, rebalancing, or any other needs, retail investors are forced to sell to others who might be better informed. Issues are two fold – quality and independence of the information. Top sources of information for retail investors are:
Telegram channels or WhatsApp groups: they lack credibility and moreover focus on trading
YouTube – good for beginners; most of the influencers end up marketing for the discount brokerages
Newspapers, TV channels – good for news (macro); do not provide linkage or relevancy to stocks (micro)
Twitter – Bombarding of news; 98-99% is noise which needs to be ignored
Advisors with no skin in the game - we do not know the motivations or incentives behind their advice
Brokerages – their revenue depends on the amount of transactions/trading; is it in their interest to give long time advice which may hurt their revenue? Some of the brokerages like ICICI Direct do provide basic research but its not in easy to read format for an ordinary retail investor
The playing field is not level for a retail investor to earn long term returns.
2. Biases - We, as sapiens, come with emotions and biases which have helped us survive over generations but now lead to lower returns as retail investors. Everyone including legendary investors like Warren Buffet, Charlie Munger or Rakesh Jhunjhunwala suffers from these same biases (Overconfidence, Disposition effect, Sensation Seeking and Anchor Bias). Trick is to know them and avoid them while investing. We have covered these biases below.
(A) Overconfidence - Overconfidence can partly explain the relatively high turnover rates and poor performance of individual investors. Retail investors have turnover which is c. 8 times an institutional investor:
Individual investors have low holding period or high churn rate as compared to larger investors (example – Rakesh Jhunhunwala holds stock for approx. 3.5 years vs less than 1 year for most of individual investors) and institutional investors.
One variety of overconfidence is a belief that one knows more than one actually does, which is sometimes labeled “miscalibration” or “over-precision”. We miss the wood for the trees. A second variety of overconfidence is a belief that one is better than the median person, which has been (mis)labeled the “better-than-average” effect. Men, who are more prone to be overconfident than women, trade more and perform worse than women.
(B) Fear of regret (Disposition effect) - Faced with the prospect of selling a stock, investors become emotionally affected by the price at which they purchased the stock. So, we avoid selling it as a way to avoid the regret of having made a bad investment, as well as the embarrassment of reporting a loss. Individual investors typically sell the profitable stocks and hold on to the loss-making stocks.
(C) Sensation seeking - A noncompeting explanation for the excessive trading (low holding period) of individual investors is the simple observation that trading is entertainment and appeals to people who enjoy sensation seeking activities such as gambling. Investors tend to trade more when they are free and do not have any other avenue of sensation seeking. We have seen this happening during COVID 19 which grounded us.
(D) Anchor bias - In the absence of better or new information, investors often assume that the market price is the correct price. People tend to place too much credence in recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities. In bull markets, investment decisions are often influenced by price anchors, which are prices deemed significant because of their closeness to recent prices. This anchoring heuristic makes the more distant returns of the past irrelevant in investors' decisions. Investors get optimistic when the market goes up, assuming it will continue to do so. Conversely, investors become extremely pessimistic during downturns.
How can a retail investor overcome these reasons for underperformance?
Now, we know the reasons for underperformance faced by the retail investor. Good news is that many legendary investors have been able to overcome these in a methodical way. They were able to do it by:
Good quality and independent source of research/articles
Stock specific analysis; avoid too much news or macro
Read alternate point of views (articles) on the stocks which we like
Challenge our analysis/hypothesis - Ask the question before investing – What can go wrong? What are the chances of it happening?
Continuous learning from others (social)
Being humble & grounded
It’s easier said than done. Better start early!
SocInvest has been created to provide support to the Retail Investors in overcoming these reasons for underperformance. One day/step at a time.
About the Author
I have over 15 years of experience in venture capital, private equity and investment banking in India and Middle East across a wide variety of sectors. I was last working with Majid Al Futtaim Holding (MAF), a leading conglomerate in Middle East, to look after investments, M&A and venture capital. I have prior experience in India with Tata Capital (Private Equity), Merrill Lynch (Investment Banking or IB) and Ambit Corporate Finance (IB). I bring the long-term ownership mindset to the analysis.
I graduated from the MBA program of the Indian Institute of Management Lucknow (2005) after completing the Bachelor of Technology program at the Indian Institute of Technology, Kharagpur (2002).
I am an Insignificant Investor in the public market and co-founder of SocInvest.