The return earned by an average investor is lower than return earned by the underlying investment
By Mayank Joshipura
Behaviour Gap is equal to investment return minus investor return. That is the way Carl Richards defines it. The return earned by an average investor is lower than the return earned by underlying investment! Investors’ desire to chase the dream of buy–low and sell-high and earn by adding timing alpha to underlying investments return leads to opposite outcome.
Why is the investor’s return lower than investment return? Well, we all are human beings and succumb to greed and fear which leads to herd behaviour and eventually results in performance chasing, buying after the investment has gone up and selling after it has gone down.
The irony is that the desire to add positive timing alpha to the investment portfolio is the key reason behind the behaviour gap and inferior investor return. Take the case of asset allocation decision. If you had exited Indian equity in the beginning of 2008 and parked your funds in gold at the same time and then exited gold and entered Indian equity in April 2009, you would have made a fortune.
Where is the evidence?
Timing is a complex decision as it requires you to make two correct decisions, back-to-back. First, when to buy and second, when to sell. Now, let us say the probability of buying or selling at the right time for an average investor is 50%. The probability of both buying and selling at the right time, one after the other, is just 25%. Making things more complicated, most of us suffer from disposition effect: our tendency to sell winners too early while holding onto losers for too long. Well, it looks difficult in theory but where is the evidence of the behaviour gap?
There is overwhelming evidence for the behaviour gap or performance chasing behaviour. Morningstar reports annual behaviour gap across mutual funds categories for the US market for many years and it is close to 2% per annum. Which means an investor earns a 2% lower return annually compared to the underlying fund’s return. Dalbar confirms a rather unfortunate trend, we all end up buying high and selling low. For the 20-year period from 1996 through 2015, equity mutual funds delivered an annual return of 8.2% whereas equity investors earned 4.7%. The large chunk of this difference is because of bad buying and selling decisions on investors’ part. Vanguard founder Jack Bogle reports that an average equity mutual fund gained 173% from 1987 to 2011, but an average equity mutual fund investor earned only 110%! The evidence from India is no different. Both individual investors and professional money managers have succumbed to performance chasing behaviour.
Clear the noise and stay on course
While tactical asset allocation calls for buying and selling different asset classes at the right time and earn superior returns, as reported earlier, it’s easier said than done. Such efforts have led to inferior investors’ returns. It’s a better idea to focus on your risk profile, financial goals, and go for strategic asset allocation and stick to it. Maybe once in a year, do necessary rebalancing to account for the relative performance of various asset classes and bring the asset allocation back to target levels.
You don’t need to check your portfolio every day. No need to listen to any forecasts about asset classes or economy and losing sleep. All these leads to bad investment behaviour. Remember, we have not invested in one asset purely because we don’t want to worry about how a particular asset class behaves in a quarter or a year. Follow a simple process and take it seriously. Don’t succumb to performance chasing behaviour, and that is the biggest contribution that you can make towards your financial well-being.
The writer is professor (Finance), School of Business Management, NMIMS Mumbai