At first glance, investing passively may seem easy. Pick a low-cost fund or funds reflecting a broad market index then hold it forever and watch your money grow. The idea behind passive investing makes sense. As long as you don’t touch the money invested, your returns will mimic those of the index minus any fees—which tend to be small for these types of funds. Over long periods, market returns have been pretty good! Unfortunately, most people don’t actually achieve these types of market like returns because not touching the money is a lot harder psychologically than most folks appreciate. True passive investors—those that can sleep soundly at night despite all the ups and downs of the market—are rare. Why? We’re human! Humans have emotions, and unbridled emotions can get in the way of being a disciplined investor.
Emotions and Investing
Perhaps the most difficult part of a passive strategy is the psychological strain it puts on investors. Buying a fund that mirrors an index and watching your portfolio rise to new highs in a low-volatility market is easy. The real test comes during negative market volatility, such as in the depths of a correction or bear market when you have to sit and watch your account value drop every day. This is when many investors feel the urge to take action, sell out and “stop the bleeding.” This is also where investors make some of their biggest investing mistakes that can materially detract from reaching their goals.
Timing the market accurately and consistently is difficult. Nearly impossible. Investors often choose to move in and out of the market at the wrong times. Or over-concentrate in a particular “hot” sector or part of the market just as its performance is peaking. Incorrectly timing the market can be the difference between retiring on time and pushing your retirement date back a few years.
A market research firm, DALBAR, Inc., does an annual study titled, “The Quantitative Analysis of Investor Behaviour.” The study compares equity and fixed interest market returns to those of the average US mutual fund investor’s return over the past 25 years. Equity markets are measured by the S&P 500—a US large-cap equity index. The 2018 edition of this survey showed the average equity fund investor earned an annualised 7.9% return compared to the S&P 500’s 9.7%—that’s a difference of nearly 2%.[i] Whilst 2% may not seem like the end of the world for some, Exhibit 1 shows over time just how much impact a 2% difference can have.
Exhibit 1: Hypothetical Growth of $1 Million Invested 25 years, 31/12/1992 – 31/12/2017
Source: “Quantitative Analysis of Investor Behaviour, 2018,” DALBAR, Inc. www.dalbar.com. FactSet, as of 06/04/2018. Barclays US aggregate Government Treasury Total Return Index from 31/12/1992 – 31/12/2017. The characteristics of the above study are shown in US Dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns, and other noted characteristics.
DALBAR attributes investors’ longer-term underperformance to “psychological factors” that can result in poor market timing decisions. Once these psychological factors begin to set in, investors make mistakes. They buy high and sell low. To be a passive investor, you must have nerves of steel to withstand all the emotions that comes with investing in the stock market.
Chasing Better Returns
According to DALBAR, the average holding period for all equity mutual funds is around 4 years. For a passive strategy to work properly, you cannot change your strategy every 4 years.[ii] But pride can make strategy shifts very tempting. For some, successfully managing their own finances gives them a great deal of pride. In an attempt to “do better” and increase their sense of pride, investors often switch to indexes that are performing better. Consider an investor in the 1990s who decided he would passively invest in the MSCI EAFE, an index that tracks non-US developed markets. As the late 1990s approached, he might have noticed how well US technology companies were performing and decided to shift his investments to track the NASDAQ—a US technology-focused index. Whilst this shift likely paid off at first, eventually the US Technology sector plummeted and this investor would have been left watching his portfolio drop in value. By changing his focus to capture better short-term returns, he likely set himself further back from reaching his long-term goals.
Behavioural finance tells us human brains aren’t hardwired to endure the volatility associated with owning stocks. Whilst just “setting it and forgetting it” may seem easy in practice, greed and fear are investors’ worst enemies when it comes to managing their own money. Even professionals who rationally know that market volatility is normal can get distracted amidst periods of high volatility and make rash decisions.
What Kind of Investor Are You?
Maybe you are a mentally tough investor who can keep control of their emotions and stay disciplined to a passive investment strategy. If so, congratulations! If you can stay disciplined, chances are you will do better than most investors. However, for most people a passive investment strategy is only good in theory—not practice—for the simple reason that we’re all human. Without proper discipline and investment counsel to help you stay disciplined, you can fall victim to common human emotions like greed and fear. These ingrained emotions make passive investing is anything but easy.
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[i] “Quantitative Analysis of Investor Behaviour, 2018,” DALBAR, Inc. www.dalbar.com. FactSet, as of 06/04/2018. Barclays US aggregate Government Treasury Total Return Index from 31/12/1992—31/12/2017.Returns are presented in US dollars. Currency fluctuations between the US Dollar and the pound may result in higher or lower investment returns.