6 Startling Reasons DIY Investors Fail to Beat Professionals — Never Mind the Market!
Understanding Why The Odds Are So Heavily Stacked Against Those That Go It Alone
Several studies emphasize the consistent underperformance of retail do-it-yourself (DIY) investors compared to the market. Many individuals choose to handle their own investment portfolios due to negative experiences with previous money managers or a lack of trust in traditional “financial advisors” — a term often, associated with various roles like insurance salesman, mutual fund salesman, annuity salesman, money manager, and more. Some DIY investors believe they possess the intelligence and time to manage their money more effectively than others. However, empirical data supports the conclusion that, on average, they are unable to outperform professional management.
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It Seems Lawyers Figured This Out Decades Ago...
“A lawyer who represents himself has a fool for a client.” This expression emphasizes the challenges and risks associated with individuals choosing to act as their own defense attorney in legal matters. It underscores the difficulties of maintaining objectivity, navigating complex legal procedures, and making rational decisions when personally involved in a case. The implication is that seeking professional legal counsel is a wiser choice to ensure a fair and effective defense — and these are professionals. These are not Do It Yourself Lawyers who choose to manage their own legal affairs.
Dalbar Study
Among the notable studies on investor behavior and performance is the annual Qualitative Analysis of Investor Behavior conducted by Dalbar. This renowned analysis leverages data from reputable sources such as the Investment Company Institute, Standard & Poor’s, Bloomberg Barclays Indices, and proprietary databases to assess mutual fund investor returns against relevant benchmarks. The term ‘average investor’ in this context refers to individuals engaging in mutual fund transactions, including sales, redemptions, and exchanges. It is essential to note that this definition excludes investors who purchase individual securities, as measuring such activity is considerably more challenging, though there is a suspicion that their performance may be comparable, if not worse.
The chart below illustrates the performance of retail do-it-yourself (DIY) investors in comparison to the S&P 500. Regardless of the time frame under scrutiny, the outcomes consistently indicate that average investors have consistently trailed behind a buy-and-hold strategy focused on the S&P 500 — at times, by a significant margin. This challenges the notion of avoiding advisory fees, as the annualized underperformance exceeds 5%. In light of these findings, some average investors may find it more beneficial to adopt a less active approach or consider engaging the services of an investment advisor portfolio manager.
Various factors contribute to the consistent underperformance of the average retail investor compared to a straightforward buy-and-hold strategy. However, I’ll highlight just a few that I frequently encounter:
Psychology Plays A Critical Role in The Performance of The DIY Investor
The psychology of DIY investors plays a crucial role in shaping their investment decisions and overall financial outcomes. Many do-it-yourself (DIY) investors face a timing challenge, often due to an overconfidence in their ability to predict market movements. Instead of strategically buying low and selling high, they frequently find themselves selling low and buying high. The typical scenario unfolds like this: when the market shows signs of decline, investors often hold onto their positions, hoping for a future recovery. Selling a losing position may feel like admitting defeat. As the market continues to slide, panic sets in, fueled by alarming media narratives. Some investors start selling, and, by this point, many institutional investors have already exited. Prices continue to drop, triggering more panic and eventually leading even the most steadfast investors to sell — at the market bottom. This cycle highlights the importance of realistic self-assessment, emotional awareness, and the adoption of disciplined investment strategies to navigate market fluctuations effectively. Here are some key aspects of DIY investor psychology:
After everyone sells in panic, the big institutional investors notice that things are cheap enough to start buying again, even if we haven’t hit the lowest point. On the other hand, regular folks are still feeling the pain, avoiding looking at their investment statements, and sticking to old, negative news.
While individual investors are catching up, institutional investors are already thinking ahead. They see signs that things are improving and expect it to boost stock prices eventually. When regular investors finally decide to jump back in, they often miss a big part of the market recovery. This delay means they end up buying when prices have already gone up a lot. So, staying updated and being ready to act can make a big difference in catching the right investment opportunities.
“Only A Sith Deals In Absolutes” — Obi Wan Kenobi
Another reason why DIY investors may not do well is the idea of either being all in or all out of the market. This simplification suggests that regular investors can perfectly time when to jump in or out. A smarter way might be to slowly invest more when things look good and pull back a bit when there’s more risk or uncertainty. This gradual approach helps manage changes in the market more smoothly and could improve overall results.
I like to think of managing a portfolio like driving on a long road trip. When the weather is good and there’s little traffic, we can speed up a bit. If it’s lightly raining, we might slow down and be more careful. A heavy downpour could make us slow down even more. If there’s some traffic (like noise or added risk), we might further reduce our speed. But it’s only when the storm is so severe that we can’t see anything that we’d consider pulling over completely.
However, when it comes to investing, people often pull over too much. Average investors tend to exit the market entirely when they want to reduce risk, instead of just slowing down a bit by adjusting their positions or cutting back on some investments. This analogy helps illustrate how a more gradual approach to managing risk in a portfolio might be wiser than making sudden and complete exits from the market.
No Strategy
In my role as an investment advisor portfolio manager, I’ve come across numerous portfolios that feature excellent individual investment ideas but lack a cohesive strategy. It’s akin to having a pantry stocked with flavorful ingredients that, when combined, don’t create anything remotely appetizing. Effective money management begins with developing a clear strategy for portfolio management — a kind of recipe.
Think of it as deciding what you want to cook. Will your approach be aggressive or conservative? Are you aiming for income or growth? How much risk are you comfortable with? What’s your investment time horizon? These considerations, among others, shape how your portfolio should be managed and the specific positions you should invest in, along with the allocated amounts. Just as you need to know your recipe to determine the necessary ingredients and quantities, understanding your financial goals and risk tolerance is crucial for constructing a well-managed portfolio.
No Process
The absence of an investment strategy often indicates the absence of a well-defined investment process. Having a structured investment process is vital for investment advisors and portfolio managers to assess and enhance their performance. In my due diligence on the portfolio, while performance is a key factor, I dedicate more time to scrutinizing the process. Performance, on its own, might be attributed to luck unless it proves to be repeatable, and it’s the investment process that renders performance consistently repeatable. Understanding and evaluating this process is paramount for making informed decisions in the world of investment management.
A comprehensive investment process typically encompasses various criteria, including:
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Professional Investment Advisors and Portfolio Managers typically adhere to a disciplined process that serves as a guiding framework for their decision-making. While this process is flexible and can be adapted or improved as necessary, the crucial aspect is having a structured approach in place. On the other hand, DIY investors generally lack a defined process. Instead, they may have a collection of individual investment ideas without a clear explanation of how these ideas came together or why they remain in the portfolio. Having a well-established investment process helps bring clarity and coherence to decision-making, a critical element often absent in the approach of many individual investors.
No Discipline
Even investors who have carefully outlined their investment strategy and formalized a robust process often struggle with maintaining discipline. Frequently, exceptions are made based on the belief that ‘this situation is different’ or because an idea comes from a successful investor friend. While occasional exceptions might be acceptable, if they become the rule, it indicates that the established process is either irrelevant or requires adjustment to align with pertinent investment criteria.
It’s acceptable to refine a process for improvement, but when exceptions consistently override the rules, it inevitably leads to underperformance. For instance, if an investor has a rule not to invest in companies with a PE ratio above 24, a company with a PE ratio of 24.1 should not qualify and should not be included in the portfolio. If such exceptions become commonplace, prompting a deviation from the established criteria, the investor needs to reconsider and possibly modify those criteria to maintain the integrity of their investment approach.
Too Much Concentration
Investing in a well-diversified index fund like SPY provides an investor with exposure to 500 stocks. If an unlikely event occurs, causing any one of these stocks to go to zero, it would likely result in a loss of just $2,000 on a $1 million portfolio, depending on the weighting of the company in the index going bankrupt. However, many investors may concentrate their investments in only 25–30 individual stocks. While this number is reasonable, as an individual investor may find it challenging to adequately follow more stocks, it still may not offer sufficient diversification in some cases. If one of these concentrated stocks goes to zero, the potential loss could be $40,000 or more, underscoring the importance of diversification to manage risk effectively.
When The Rubber Meets the Road..
The challenge of professional money managers struggling to consistently outperform an index over extended periods raises the question of whether a retail investor, even an exceptionally intelligent one, can achieve better results. In all likelihood, they will not. When you factor in several behavioral biases that retail investors may be unaware of, coupled with a lack of strategy, discipline, and poor portfolio management — manifesting as excessive concentration or impulsive reactions — one of the only remaining factors for potential outperformance is luck.
Without a structured approach, behavioral awareness, and disciplined decision-making, relying on luck generally becomes the sole, unreliable factor that could lead to better-than-average returns. Establishing a well-defined strategy, maintaining discipline, and actively managing a diversified portfolio can play crucial roles in improving an investor’s chances for success over the long term.
Certainly, there’s a chance of outperformance in investing, just like you can have a winning weekend in Vegas. However, relying on such sporadic success over the long term is more often than not, fraught with risk. Just as consistently expecting positive outcomes in Vegas generally leads to significant losses.
Those glittering hotels in Vegas didn’t get built on consistent wins from gamblers. If you’re interested in investing, it’s essential to learn the proper way to manage your portfolio, not merely relying on random stock picks. Alternatively, consider seeking the guidance of a trustworthy investment advisor or portfolio manager. While professional advisors might not be infallible, they provide an objective perspective, helping you make more informed decisions and avoid the pitfalls associated with speculative and impulsive investing.
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Joe A. Macek, FMA, CIM, DMS, FCSI
Investment Advisor, Portfolio Manager
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