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According to the latest research, the average American investor underperforms the market over the long term -- and by a huge margin. And yet the reasons for that poor performance are completely avoidable. Here's what the data tells us about the average investor's returns, along with four easy principles that can ensure you do better.
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Wait, the average investor does how badly?According to Dalbar's 2015 Quantitative Analysis of Investor Behavior, the average mutual fund investor has underperformed the market over all the time intervals that were examined, which range from one year to three decades. And the underperformance is astonishing.
The study also found that in the 20-year period ending Dec. 31, 2013, the average investor (in all varieties of mutual funds) only managed an average total return of about 2.5%. According to Richard Bernstein Advisors, this performance was even worse than that of three-month Treasury Bills -- which are considered just a step up from keeping money in cash.
What's to blame for this poor performance?In its report, Dalbar identified nine self-destructive behaviors exhibited by investors that contribute to the dismal performance. For example, investors tend to have a herd mentality, copying the behavior of others no matter what the outcome. They also tend to have knee-jerk reactions to news without considering all of the relevant information.
Common sense tells us that the goal of investing is to buy low and sell high, but thanks to our emotions, we tend to do the exact opposite. When the market goes up and up, that's when investors pump the most money into stocks and funds. And when individual stocks have a huge winning streak, investors see all of their friends making money and buy shares at the highs. Sure, an investment in Tesla Motors when the stock was at $20 would have been great, but chasing the stock into the $200s is the exact opposite of "buy low."
Conversely, when markets go down, we tend to panic and sell. Investors often have their worst performance relative to the market during crashes and corrections -- in fact, six out of the 10 worst months for investors over the past three decades took place in 1987 (when Black Monday occurred), 2000 (tech crash), or 2008 (financial crisis).
Bear in mind these aren't annualized figures. In October 2008, the average investor underperformed the S&P 500 by a 7.41% margin in just one month. This was during the financial crisis, during the same month when the infamous bailout was issued. The S&P 500 lost 16.8% for the month. However, the average investor's panic-selling resulted in a 24.21% loss -- much worse than it needed to be.
Four ways to be better than averageIt's impossible to guarantee that an investor will make money over any time period -- especially over just a few years. However, the performance gap between the average investor and the S&P 500 could be eliminated, or at least greatly reduced, by following a few simple guidelines.
- Don't try to time the market.Buying a stock or fund because you think it's at the bottom, or selling one because you think it has topped out, is almost always a losing battle. Investors who decided to buy Radio Shack after it dropped below $1 per share, or who sold Amazon.com the first time it surpassed $300, can tell you that. Instead of focusing on the share price, buy stocks that represent a business you'd like to own for the next 10, 20, or 30 years. Or, if you're a mutual fund investor, invest in quality funds regardless of what the market is doing.
- Don't chase hot stocks. Chasing stocks on their way up is too much of a gamble. Sure, a stock that has quadrupled in value over the past year could continue on its upward trajectory -- or it could come crashing down as soon as anything goes wrong.
- Don't panic during crashes.Panic-selling is the worst investment move you can make during tough times. Those investors who sold out of fear in late 2008 simply turned paper losses into real losses, and they also missed the rally that took place over the next several years.
- Use the power of dollar-cost averaging.Dollar-cost averaging is a strategy that involves investing equal dollar amounts at regular time intervals (say, $500 every other month). Not only does this take emotion out of the equation, but it actually gives you a long-term mathematical advantage, since you buy more shares when prices are low and fewer shares when prices are high. For a thorough description of the incredible power of dollar-cost averaging, check out this article.
Above-average returns are easy to achieveThe average American investor has produced dreadful investment returns over the past three decades, but you don't have to be average. Good investment returns don't require any sort of magic formula -- just the discipline to recognize your emotional weaknesses and take them out of the picture.
The article The Average American's Investment Returns -- and How You Can Do Better originally appeared on Fool.com.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Amazon.com and Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.