You can’t control the markets, but you can control how you react to the markets

Money decisions often come from the head and the heart, a delicate combination of logic and emotion. A trusted adviser should be able to identify and talk through the reasons for decisions in a way that addresses both aspects with open, regular and realistic conversations.

Dalbar Inc. is a leading investor research firm that has studied investor behaviour since 1976. The results of their research consistently show that the average investor earns below-average returns.

For the 20 years ending Dec. 31, 2008, the S&P 500 average equity mutual fund achieved 8.35% a year. A pretty attractive historical return. Yet the average equity fund investor earned a market return of only 1.87% a year during the same time frame.

These two numbers will bounce around from year to year, but the disparity remains eerily constant over 20-year periods. Yes, you have it. The average investor is underperforming – to a grotesque extent – their own investments.

To achieve the first result, the investor need only to have purchased the fund, elected to re-invest dividends, put it in a drawer and forgotten about it.

To achieve the second result one of three things likely happened (and as an adviser, I can attest that I see evidence of this behaviour on a regular basis):

1. The “Average Equity Fund Investor” possibly bought only the funds with the recent “hottest performance.” When those funds inevitably cooled off after a period of hot performance, the investor switched to the next crop of red hot winners – and may in fact have done this repeatedly.

2. In October, 1987, and/or October 1990, and/or August 1998 and/or October 2002 and/or October 2008 – or any of the other major bottoms in the last 20 years when equity mutual funds went into massive net liquidation – our Average Equity Fund Investor went to cash in panic.

3. Conversely he doubled up on Asian stocks, technology, biotech, dot.com, resource or whatever the flavour of the day in boom times.

Behavioural finance can help explain some of these irrational actions. The following terms may not be familiar to you, but are some of many concepts studied endlessly in psychology journals around the world.

Loss Aversion: Expecting big returns with low risk.

Narrow Framing: Making decisions without considering all implications.

Herding: Copying the behaviours of others even in the face of unfavourable outcomes.

Media Response: Reacting to news without reasonable examination.

Optimism: Believing that good things happen to “me” and bad things happen to “others.”

Two excellent references for both investors and investment advisers for insight on how behaviour affects your investment decisions are the new Nick Murray book Behavioural Investment Counselling and the easier read, the Little Book of Behavioral Investing: How not to be your own Worst Enemy by James Montier.

Money decisions often come from the head and the heart. A delicate combination of logic and emotion.  A trusted adviser should be able to identify and talk through the reasons for decisions in a way that addresses both aspects with open, regular and realistic conversations.

Lara Austin is an Investment Adviser at the Courtenay office of RBC Dominion Securities (Member–Canadian Investor Protection Fund). This article is for information purposes only. Before taking any action based on information in this article, consult with a qualified adviser.