04/02/2022
WHY DO RETAIL EQUITY INVESTORS USUALLY UNDERPERFORM?
“The investor’s chief problem, and even his worst enemy, is likely to be himself.” – Benjamin Graham
In the investment process, investors often experience the “roller coaster of emotions”. If that scenario looks familiar to you, you’re not alone. For retail equity investors in particular, the investment journey is full of psychological pitfalls. Only by becoming aware of and actively avoiding behavioral biases can investors reach impartial decisions. It is more easily said than done.
Investment scholars have observed that there are two distinct sets of factors that drive retail investors' decision to invest:
(i) Rational factors related to traditional finance and:
(ii) Irrational factors that come under the domain of behavioral finance
Traditional Finance assumes that investors act rationally while making a decision, considering all available information. We like to think we invest rationally, but the studies in Behavioral Finance have shown there are social, emotional and even cognitive factors that can affect our investment decisions. Those factors, also called Behavioral Biases, can undermine our decision-making ability and impact our long-term success. And these biases are more common than you might think.
Let’s explain this further. The proponents of market efficiency (assumption that markets are rational) use theories of traditional finance to explain the anomalies in the market. In reality, humans do not act rationally. In fact, humans often act irrationally–in counterproductive. 80% of individual investors and 30% of investment firms are more inertial than logical. These deviations from theoretical predictions have paved the way for behavioral finance. Behavioral finance explains market anomalies through behavioral biases. According to that, the reason long-term investors like Warren Buffett can consistently earn profits is because they are successful in actively avoiding behavioral biases in their investment decisions.
What are these biases? Herd behavior (the wisdom of crowd, follow the trend), Loss aversion (avoid loss is my primary goal), Confirmation bias (want to hear only things that align with my perceived outlook), Present bias (overvalue immediate reward), Anchoring (focus too heavily on one piece of information), Home country bias (preference for domestic investments) are some of them.
Retail investors, in general, are prone to all these biases as their access to information is also limited. Confirmation bias, herding and over focus on immediate reward usually rule their investment decisions. These are indeed barriers to investment success. These biases are the reason why over a 30-year period, the average US retail equity investor achieved a return of 3.8% per annum only while the S&P 500 returned 11.1% per annum.
Institutional investors on the other hand are the big guys in the block – the elephants – holding more than 70% of all stock trading volume. They have to refer to a set of guidelines (strict rules) and are less prone to these biases compared to retail. Their asset allocations and risk taking is all guided by these set of rules. Due to their sheer size and access to market, they usually have first hand access to information and enjoy preferential rates. They move large blocks of shares and have a tremendous influence on the stock market's movements. Statistically, the chances of achieving higher returns on your investments to meet your financial goals is higher if you leave these investment complexities to these specialists.
