The average investor makes poor returns on his money. In 2015, Dalbar's Quantitative Analysis of Investor Behavior (QAIB) reported that the average 30-year annualized return for investors in blended mutual funds was 1.65%. Fixed-income fund investors fared even worse, returning 0.59% annually. Meanwhile, the Standard & Poor's (S&P) 500 Index advanced by 10.35% per year over the same period, while the Barclays Aggregate Bond Index returned 6.73% annually.
Investors have themselves to blame when assigning fault for underperforming the market so severely. Several decision-making errors prevent average investors from fulfilling their potential. Investors fail to make appropriate buy and sell decisions based on time horizon. They avoid profit-taking on winners and fail to cut losers with poor long-term outlooks. They chase popular stocks instead of following Warren Buffett's advice and seeking out ones the market undervalues. Lastly, average investors take risks not commensurate with potential rewards.
A smart investor knows his time horizon and makes buy and sell decisions accordingly. With a 20-year time horizon, the best time to purchase new shares is when the price drops. Even if it falls further, the investor has years to recover from losses. Strategies such as dollar-cost averaging work well with lengthy time horizons, as it ensures more shares are purchased when the price is low and less are bought when the price is high.
An investor with a short time horizon, such as 24 hours to a week, should be more reticent about buying on dips. If the stock takes too long to recover, the investor does not make his money back. Unfortunately, the average investor often follows the opposite of this protocol. He puts more money in long-term investments when they are hot and loads up on short-term investments on dips.
Profit-Taking and Loss Mitigation
A tenet of buy-and-hold investing is resisting the urge to cash in after a gain or dump a security at the first sign of trouble. That said, the best investors are in tune with their portfolios and recognize when a stock is overheated or, conversely, when a struggling security has little chance of recovering. In these situations, savvy investors do not hesitate to take some profit on the winner or sell shares of the loser to mitigate losses.
The average investor lets the winner ride and holds on to the loser in hope of cashing in on a recovery, consequently leaving a lot of money on the table.
Chasing Popular Stocks
Chasing popular investments usually results in overpaying. Dotcom investors in early 2000 and real estate investors in 2005 learned this the hard way. Just because something is currently hot does not make it a good long-term investment. Warren Buffett amassed his fortune by investing in stocks the rest of the market was ignoring. In other words, he went against what was currently popular. The average investor follows herd behavior, buying shares that are overvalued.
Understanding Risk and Reward
Risk and reward go hand in hand. However, average investors take unnecessary risks not justified by potential rewards. For example, holding an overnight position in day trading represents a risky proposition. Too much could happen between the closing and opening bells, such as a major news event.
An investor who does not understand risk and reward holds on to a high-performing stock even with industry news emerging that portends trouble. While average investors fail to balance risk and reward appropriately, smart investors employ cost-benefit analysis to determine when it is suitable to take a risk.
Applying This Knowledge to XOP Investors
The SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA: XOP) experienced high volatility from 2014 to 2016. Its caprice has made savvy investors lots of money and lost mediocre investors equally large sums. It traded as high as $80 per share in July 2014 before falling to $22 per share in February 2016. It has since embarked on a slow but steady climb and, as of July 2016, traded at $34 per share.
Consider how a savvy investor versus an average investor might have applied the four tenets above to this ETF. Recognizing the unlikeliness of oil prices staying depressed forever and understanding that the ETF is effectively on sale, a savvy investor with a lengthy time horizon would have loaded up on it in February 2016. Meanwhile, the average investor would have sold out of fear and missed the incipient rebound.
Smart investors with shorter timelines recognized the need to cut losses when oil went into a tailspin in late 2014. Less-skilled investors could not bear to sell at a loss and held on longer than they should have while hoping for a recovery.
When seemingly everyone was bearish on oil, average investors avoided this ETF because of its unpopularity. On the other hand, savvy investors went against the crowd to buy it and enjoyed a 54% gain from February to July 2016.
Smart investors took the right amount of risk with regard to such a volatile ETF. Average investors either avoided it altogether or purchased too many shares at the wrong time.