Why is having an investment philosophy important? For starters, building and maintaining a portfolio of assets void of a solid investment philosophy exposes investors to every capricious view brought about through the latest news story… not the ideal source for investment advice.
Furthermore, allowing emotions to make rules pertaining to investing typically undermines wealth accumulation. In the long run, the sporadic and emotional changes to one’s portfolio become a drag on performance.
This brings us to the premise for having a sound investment philosophy – managing behavior. On average, trying to time the market proves disastrous for investors. Yes, some might fare well for a while but inevitably the market wins. When a portfolio is driven by emotion, market timing becomes the philosophy. When bad news arrives, investors react by selling, because of fear. When good news develops, investors react by buying, because of greed, or some form of it.
These behaviors over the years produce subpar results because investors, using emotions as a gauge, buy when the market is high and sell when the market is low… counterproductive to wealth accumulation.
Dalbar publishes a telling report each year titled Quantitative Analysis of Investor Behavior (QAIB). The report compares investment returns to that of investor returns for 20-year intervals and has been published for several years. Each report tells the same story. Average investors woefully underperform markets.
To get a better understanding let’s discuss the difference between investment return and investor return.
Investment return is the total period return (excluding the buying and/or selling habits of average investors) over the said time period. Dalbar’s QAIB uses the S&P 500® Index as their benchmark for the equity portion of the analysis. So investment return in the QAIB is simply calculating the performance of the S&P 500® over the 20-year time period studied.
Investor return is quite another story. Investor return is what average investors realized in returns during the same time period. This includes all of their buying and selling decisions.
You would think efforts made by investors to avoid market drops and exploit market gains would amount to superior performance over market returns. Not so, not even close. On average, the difference in total return is staggering.
As reported by the QAIB (2012) the S&P 500® returned 7.81% over a 20-year period ending in 2011, the average equity investor earned just 3.49% in the same time period. So the average investor underperformed the S&P 500® by 4.32%… this figure is annualized underperformance. Keep this up and you can see how building wealth gets difficult. Moreover, adjust this figure for inflation and real returns are even worse for the average investor.
Bond investors did not emerge unscathed. They averaged 0.94% while the Barclays Aggregate Bond Index earned 6.50%. The average bond investor underperformed the index by 5.56% in the same time period.
If this be the case, a simple buy and hold strategy would undoubtedly prove to be a better option. While not advocating a true buy and hold strategy, the results are obviously superior when matched against emotional investing.
The point being made is this; placing trust in a sound investment philosophy is a proactive approach to managing wealth. Rules are established long before events call them into use. An investment philosophy introduces discipline and confidence into the process while eliminating the perils of emotional investing. Fear, or greed, is the enemy of rational thought and investors do well to remove it from the equation.