Why Average Investors Earn Below-Average Market Returns

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Research by Dalbar, Inc., a company that studies investor behavior and analyzes investor market returns, consistently shows that the average investor earns below-average returns.

For the 20 years ending December 31, 2019, the S&P 500 Index averaged 6.06% per year. The average equity fund investor earned a market return of only 4.25%.

Why is this?

Investor behavior is illogical and often based on emotion. That does not lead to wise long-term investing decisions. Here's an overview of a few typical money-losing moves that average investors make.

Buying High

Studies show that when the stock market goes up, investors put more money in it. And when it goes down, they pull money out. This is akin to running to the mall every time the price of something goes up, and then returning the merchandise when it is on sale—but you are returning it to a store that will only give you the sale price back. This irrational behavior causes investor market returns to be substantially less than historical stock market returns.

What would cause investors to exhibit such poor judgment? After all, at a 6% return, your money will double every 12 years. Rather than chasing performance, you could simply have bought a single index fund and earned significantly higher returns.

Want to estimate how long it will take for your investment to double? Use the Rule of 72. Divide the number 72 by the anticipated rate of return to arrive at a rough estimate.

Overreacting During Times of Uncertainty

The problem is that the human reaction, to good news or bad news, is to overreact. This emotional reaction causes illogical investment decisions. This tendency to overreact can become even greater during times of personal uncertainty—near retirement, for example, or when the economy is bad.

There is an entire field of study that researches this tendency to make illogical financial decisions. It is called "behavioral finance," and it documents and labels our money-losing mind tricks with terms like "recency bias" and "overconfidence."

Investors Believe They Can Predict the Future

With overconfidence, you naturally think you are above average. For example, in one study, 81% of new business owners thought that they had a good chance of succeeding, but that only 39% of their peers did. In another study, 93% of U.S. drivers rated themselves in the top 50% of drivers in terms of skill.

When it comes to investing, overconfidence causes investors to exaggerate their ability to predict future events. They are quick to use past data and to think they have above-average abilities that enable them to predict market movements.

Popular books, like Carl Richard's The Behavior Gap, also do a great job of explaining the behavioral decisions that lead to the large gap between market returns and actual investor returns. Despite the research and education, the gap continues. What can you do to avoid the fate of the average investor? 

How to Avoid Losing Money

One of the best things you can do to protect yourself from your own natural tendency to make emotional decisions is to seek professional help and hire a financial advisor. Use a disciplined screening process to find the right advisor for you.

An advisor can serve as an intermediary between you and your emotions. If you are going to manage your own investments, you'll need your own way to keep your emotions out of the buy/sell process. Consider using the four tips below to make smarter decisions.

1. Do Nothing

A conscious and thoughtful decision to do nothing is still a form of action. Have your financial goals changed? If your portfolio is built around your long-term goals (as it should be), a short-term change in markets shouldn't matter.

2. Know That Your Money Is Like a Bar of Soap

To quote Gene Fama Jr., a famed economist, “Your money is like a bar of soap. The more you handle it, the less you’ll have.” 

3. Never Sell Equities in a Down Market

If your funds are allocated correctly, you should never have a need to sell equities during a down market cycle. This rule holds true even if you are taking income.

Just as you wouldn’t run out and put a for-sale sign on your home when the housing market turns south, don’t rush to sell equities when the stock market goes through a bear market cycle. Wait it out.

4. Trust That Science Works

A disciplined approach to investing delivers higher market returns. Yes, it’s boring, but it works. If you don't have discipline, you probably shouldn't be managing your own investments.

Frequently Asked Questions (FAQs)

How do average investors buy into companies before the IPO?

The short answer to this question is that average investors cannot buy into companies before they trade publicly. The Securities and Exchange Commission (SEC) sees early investments in companies as extremely risky investments, so it imposes a wealth or income threshold to ensure that investors can afford to lose their money. These "accredited investors" include those with a net worth of more than $1 million (excluding their primary residence) or annual earned income of more than $200,000 ($300,000 for couples).

How do sophisticated investors find investments that average investors miss?

The way a sophisticated investor outperforms an average investor is known as their "trading edge." Every trader has to discover and develop their trading edge on their own. Some will find that they're better at the fundamental analysis of business financials. Others will focus on technical analysis and trading based on chart patterns.

Article Sources

  1. Dalbar, Inc. "2020 QAIB Report." Accessed April 5, 2021.

  2. Brad M. Barbera and Terrance Odean. "The Behavior of Individual Investors," Handbook of the Economics of Finance. Accessed April 5, 2021.

  3. Stanford University. "EE204: Business Management for Electrical Engineers and Computer Scientists." Accessed April 5, 2021.

  4. Corporate Finance Institute. "Overconfidence Bias." Accessed April 5, 2021.

  5. Robin M. Hogarth and Natalia Karelaia. "Entrepreneurial Success and Failure: Confidence and Fallible Judgment," Organization Science. Accessed April 5, 2021.

  6. Ola Svenson. "Are We All Less Risky and More Skillful Than Our Fellow Drivers?," Acta Psychologica. Accessed April 5, 2021.

  7. Investor.gov. "Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing." Accessed April 5, 2021.

  8. Office of Investor Education and Advocacy. "Accredited Investors — Updated Investor Bulletin." Accessed April 5, 2021.