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Meet The Individual Investor’s Greatest Enemy

If you’d ever like to meet the individual investor’s greatest enemy, that’s easy. Take a quick look in the mirror – it’s us.

I was reminded of our tendency to sabotage our own investing performance when I came across this amusing exchange between investors Barry Ritholtz and James O’Shaughnessy in Bloomberg Radio’s “Masters In Business” programme. As reported by Business Insider, the following was what caught my ear:

“O’Shaughnessy: “Fidelity had done a study as to which accounts had done the best at Fidelity. And what they found was…”

Ritholtz: “They were dead.”

O’Shaughnessy: “…No, that’s close though! They were the accounts people who forgot they had an account at Fidelity.””

Fidelity is one of America’s largest mutual fund (the equivalent of unit trusts here in Singapore) companies and they must easily have hundreds of thousands, perhaps even millions of clients.

Now, think about the implications of the anecdote I’ve just shared. Investors who’ve forgotten they’ve have a trading account would have left whatever holdings they had untouched for years. Meanwhile, you’d have the other group of Fidelity clients buying and selling shares regularly and actively… and they were the ones who did poorly!

Sources of poor returns

Taken to a logical end, it seems to me that it’s inactivity in the market which makes for great returns for investors. The implication of Fidelity’s study segues nicely into the following chart:

Average investor behaviour versus S&P500

Source: John Maxfield, Fool.com

The chart shows the annualised returns of the S&P 500 (a broad share market index in the USA) for each 20-year period ended 1998, 1999, 2000, and so on, all the way till 2013. It then compares the S&P 500’s return against the 20-year annualised return an average equity fund investor in the USA had earned.

As you can see, the differences in returns between the two are stark. In other words, while the investment’s (the S&P 500 index) gains had been more than satisfactory, the investor’s returns had been poor at best.

DALBAR, the firm responsible for the figures reproduced in the chart, basically attributes too much trading as a big reason for the average individual investor’s propensity to underperform the market. According to DALBAR’s findings, individual investors often jump in and out of their mutual funds at all the wrong times.

That finding – of investors’ tendency to time the market disastrously – is also supported by other research findings, such as those by the St. Louis Federal Reserve Bank. What the St Louis Fed found was that there’s a strong correlation between quarterly mutual fund returns and quarterly mutual fund flows. When funds perform well in a quarter, investors flock to them; when the performance turns sour, investors flee in droves. That’s harmful for investors, as explained by the St Louis Fed:

“The buy-and-hold strategy earned an average annual return of 5.6 percent in the sample period [from 2000 to 2012], while return-chasing behavior only realized 3.6 percent.  In other words, chasing returns caused the average U.S. mutual fund investor to miss around 2 percent return per year, which is very significant.”

The individual’s blame game

If you notice, a big part of the reason for the individual investor’s underperformance is a self-inflicted urge to pursue active short-term trading. For the pessimists amongst us, it’s perhaps a tragic tale of our unending ability to self-sabotage our own investing returns (just take a look at the 15-year chart above!). For the optimists (like me!), it’s actually great news to know that a big source of the damage comes from within.

That’s because unlike systemic or structural reasons which can’t be changed easily by the individual, an individual’s own investing behaviour can be tweaked right here, right now. What’s needed might just be awareness of the problem at hand.

In my personal experience, such important findings like the ones produced by DALBAR and Fidelity aren’t given enough attention in Singapore. That’s natural as they’re studies produced in other parts of the world. But, the validity and universal applicability of the findings should also be noted by us, Singaporeans.

Foolish Bottom Line

Over the past 12 years, Singapore’s share market has given satisfactory returns. The SPDR STI ETF (SGX: ES3), a proxy for Singapore’s share market benchmark the Straits Times Index (SGX: ^STI), has delivered compounded annualised gains of 8.65% from 11 April 2002 (its inception date) till 31 July 2014. An annual return of 8.65% can allow an investor to double his money every nine years – that’s not too shabby at all.

I hope that if a DALBAR-like study were to ever be done in Singapore, the average individual investor’s returns here would either meet or exceed the market’s return (though I would logically bet for an outcome more similar to what has happened in the USA).

For those of you reading this, I too hope you’d spend some time and discover how your own investing performance compares against the market benchmark. If you’ve fallen way short, it’s still not too late to confront your greatest investing enemy – yourself. Fight the urge to buy and sell shares and instead, invest for the long-term. Your portfolio might just thank you for it in the future.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.