Investment return isn't the same as investor return

Warren Buffett, the Oracle of Omaha, once said to be fearful when others are greedy, and greedy when others are fearful.

You may have your money tied up in the stock market. Perhaps you went for the “shiny objects” and bought some popular high-tech company stocks and enjoyed watching your investments grow. But lately, you’ve been startled by the falling stock prices. You are tempted to sell your investments for much less than what you paid for them, exactly the opposite of Buffett's advice.
 
I don’t blame you. That’s human nature.
 
Who wouldn’t be tempted when you see others getting fabulously rich – sometimes very quickly – on Bitcoin and Tesla stock? Never mind that you don’t fully understand your investments. After all, isn’t that the whole point of investing? To sit back and enjoy your balance go up and up?
 
But for long-term investment success, picking stocks based on past performance or trying to outguess the market is bound to fail.  
 
According to the annual Quantitative Analysis of Investor Behavior report by Dalbar, Inc., the S&P 500 returned 28.71% in 2021. The average investor? 18.39%. That’s a whopping 10% difference.
 
Wait, it gets worse.
 
Over 30 years, from 1/1/1992 to 12/31/2021, the S&P 500 returned 10.65% annually vs. average investor’s 7.13%. To put this in perspective, if you invested $100,000 in the S&P 500 on the first day of 1992, you would have ended up with $2,082,296 at the end of 2021. If you were an average investor earning 7.13%, your balance at 12/31/2021 would be $789,465.
 
In summary, it looks something like this.

Why the large difference? Why is the investor return different from the investment return?
 
One obvious reason is that investors make investment choices based on their emotions. They tend to make irrational investment choices out of fear or greed. Not surprisingly, studies have observed a close relationship between fund flows and market returns. That is, when stock prices move up, money flocks to mutual funds; conversely, you see an outflow of money from these funds when the markets tank.
 
Of course, it goes without saying that this “buy high, sell low” investor behavior is completely irrational. But, sadly, it’s quite typical. Academics refer to this phenomenon as behavioral finance. It’s the study of investor behavior – the psychology and behavior that has to do with investors chasing “shiny objects,” seeing only what they want to see, hearing only what they want to hear, and making irrational investment decisions.   
 
Knowing this, is there an antidote to such irrational investor behavior? You can consider the following:  

1. Think long-term. By default, investing is a long-term game. Why? Simply, because it’s risky. You can lose money – sometimes a lot – over a short period of time. In fact, as an investor, you should expect and accept short-term declines. It should never surprise you when your balance goes down over several weeks and months. If that happens, don’t fret. Think long-term. Stick to your program without wavering. That’s how you help yourself avoid buying high and selling low.  
2. Respect “science”. The genesis of asset allocation can be traced back to the 1952 paper, “Portfolio Selection,” by Nobel laureate Harry Markowitz. Since then, his theory (called Modern Portfolio Theory) has been developed and embellished by very smart people, including even more Nobel Prize recipients. Clearly, there is science to investing. To avoid emotional response to market volatility, you should boldly abandon your investment “strategy” based on your intuition, greed and fear, and trust the "science" of investing, namely, asset allocation.
3. Leave it alone. Professor Eugene Fama, a 1998 Nobel laureate, once said, “Your money is like a bar of soap, the more you touch it, the smaller it gets.” Investors who meddle with their investments usually end up losing money. The Dalbar study on investment return vs. investor return mentioned above bears out that fact. Invest in a broadly diversified, asset-allocated portfolio. Rebalance it annually. That should do the trick over the long run.  
4. Be humble.  William Bernstein, a neurologist and financial theorist, quipped, “There are only two kinds of investors: those who don’t know where the market is headed, and those who don’t know that they don’t know.” As Yogi Berra said, “It's tough to make predictions, especially about the future.” So, stop trying to predict where the market is headed. Don’t try to outsmart the market. Stay disciplined; stay the course.

We do not provide legal or tax advice. Readers should consult their own legal or tax advisor. There is no guarantee investment strategies will be successful. Investing involves risks, including possible loss of principal. There is always the risk that an investor may lose money. A long-term investment approach cannot guarantee a profit. Investors should talk to their financial advisor prior to making any investment decision. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.