Successful Investors Keep the Faith

Written by Andy Pratt, CFA on .

“Keep the faith!”

Long-term clients have surely seen or heard this phrase from us in a blog post or in a quarterly letter or in a meeting. It is a favorite saying of ours because it is simple advice that leads to very real value for any investor, whether a client or not.

030314bucks carl sketch jumboSource: Carl Richards, The Best Investment Strategy? Getting Out of Our Own Way

Study after study shows that investors consistently underperform market indexes. The Dalbar Quantitative Analysis of Investor Behavior found that the average equity mutual fund investor underperformed the S&P 500 by nearly 4% and that the average fixed income mutual fund investor underperformed the Barclays Aggregate Bond Index by about the same amount.

Morningstar found that investors underperformed relevant benchmarks across all types of asset classes with an average annual underperformance of 2.5% over a 10-year period. Money moved out of equity mutual funds in 2009, at the bottom of the market, and flew back in to equity mutual funds in 2013, after a huge, 30%+ year for stocks.

Sell low, buy high.

Vanguard studied investor behavior in their IRA accounts during the Financial Crisis and its aftermath finding that investors who made just one move lagged the Vanguard asset allocation benchmark by 104 basis points, or 1.04%, while investors who stuck it out beat the same benchmark by 33 basis points.

The common theme is that investors underperform and they do this largely because of self-inflicted, easy to make mistakes that are ingrained in the human psyche.

From an evolutionary standpoint, we are hardwired to feel the pain from losses more than joy from gains and, while this kept our hunter and gatherer ancestors alive, it leads to bad investment behavior. Like the investors who ran out of stocks in 2009 and piled back in during 2013, the same thing happens when active managers underperform.

Eighty five percent of the best investment managers underperformed over a three year-year period, often substantially, despite ultimately delivering top 90th percentile performance. Successful active strategies should be expected to underperform for sometimes long periods of time and we, as investors, must realize ahead of time that it will be very difficult to keep the faith during these times but that keeping the faith is our best chance at realizing the long-term returns of the strategy.

Otherwise, it is all too easy to fall prey to the Behavior Gap.