When it comes to investing, individuals often believe that they can win over everyone else and 'beat the market'. In reality, most people come up short.
According to a 2016 study titled Quantitative Analysis of Investor Behavior, the average equity mutual fund investor's annualized return over 20 years was only 4.67% versus 8.19% for the S&P 500 index.
The human factor
So why do most investors under perform the market? This may be partly explained by our human nature, and the ingrained biases and behaviors that influence our decisions. While these traits might be useful from an evolutionary standpoint, they are often detrimental to investment performance.
Part of the problem is that people tend to think that they are better at something than they actually are. There is a condition in the world of social psychology called illusory superiority where an individual overestimates their own abilities. When it comes to driving for example, one study showed that 93% of American drivers believed they were better than average, which of course isn't realistically possible.
Humans also like to adopt the herd-mentality. When the market is doing well, people invest more, however they are often too late and they miss out on the initial upside. Conversely, people panic and sell when the market dips, ensuring that their loss is locked in. In general, humans overreact to good or bad news, which leads to questionable and irrational investment decisions.
(Source: "Quantitative Analysis of Investor Behavior, 2016," DALBAR, Inc.)
It is very hard to get the upper hand when investing since information about companies is spread to everyone at the same time (this is often a legal requirement). When investing, it is important to remember that there are thousands of experts out there who analyze almost every stock and are buying and selling (setting the price) based off information they have scrutinized and analyzed.
Large investment firms use technology and complex models and algorithms to make decisions. So, unless your main job is evaluating investments, it is extremely difficult to know more than the professionals (and their computers) around the world.
Additionally, individual investors have to factor in trading costs and personal tax implications when they buy and sell individual stocks.
What the pros say
Even top investors like Warren Buffett have publicly said that it is almost impossible for most people to outperform the broader market. Buffett recommends that investors regularly buy into the market by purchasing index funds (which are similar to benchmark based ETFs).
Don't let this bring you down! Even seasoned mutual fund managers find it tough to outperform the market. Looking at a 15 year time horizon, 82% of actively managed funds underperformed the market benchmarks.
Boring is better
Since it is extremely hard for most investors to outperform the market by buying and selling individual stocks and timing market swings, you should aim to get as close to market performance as possible. This can be done by purchasing certain market based ETFs and making regular contributions to your portfolio. This strategy is called passive investing. Although you might not be able to add to conversations revolving around the latest stock tips, this boring strategy will put you ahead in the long-term.
There are a handful of Canadian companies that help individuals set up investment accounts so they can invest in the broader market at fees that are much lower than actively managed mutual funds. These services also help set your asset allocation, rebalance your portfolio, and implement tax-loss harvesting strategies.
If you are comfortable using an online self directed brokerage account and rebalancing on your own, you can create your own ETF portfolio.
The Bigger Picture
Investing is one part of your larger financial picture and it is a tool that you can use to reach your goals. It shouldn't cause you stress and take up your valuable free time.
When you make the decision to invest there are other factors to consider, like evaluating which accounts provide the best benefit from a tax perspective and matching your strategy with your personal risk tolerance.
Frame has partnered with companies that help Canadians manage their investments in a simple and low-cost manner. Taking control of your finances means having less stress today as you work towards a better future.