Q. Is there any proof that average investors' emotions interfered with their investments and led to bad results?
A. Unfortunately, that's the fact backed by years of data, just look at the results from the Dalbar's Quantitative Analysis of Investor Behavior (DAIB). Between the inception of DAIB in 1984 and 2014, average investor's equity fund annual return is only 3.69%; during the same time period, S&P 500 index's average annual return is 11.11%!
Why such under-performance? Based on Behavior Finance theory, investors should take most of the blames themselves. Herd behavior, greed, and the fear of losing money are the major drivers behind under-performance.
Here is an example and a question to test yourself: Imagine you own 2 stocks: A and B. You purchased A with $12,000, and you purchased B with $8,000. Your capital gain tax rate is 20%. Now both stocks are at $10,000 each, and you need $10,000. Which stock will you sell - A or B?
Most investors will choose to sell Stock B, because they can't face the fact they will lose money if they sell Stock A!
However, that's not the most rational decision, because if you sell B, you will pay capital gain $400, so your after-tax cash will be only $9,600. If you sell A, you will incur $2,000 loss, which will generate $400 tax loss to offset your other income, so your net proceeds will be $10,400!
That's $800 difference!
What's your answer to the example above?
A. Unfortunately, that's the fact backed by years of data, just look at the results from the Dalbar's Quantitative Analysis of Investor Behavior (DAIB). Between the inception of DAIB in 1984 and 2014, average investor's equity fund annual return is only 3.69%; during the same time period, S&P 500 index's average annual return is 11.11%!
Why such under-performance? Based on Behavior Finance theory, investors should take most of the blames themselves. Herd behavior, greed, and the fear of losing money are the major drivers behind under-performance.
Here is an example and a question to test yourself: Imagine you own 2 stocks: A and B. You purchased A with $12,000, and you purchased B with $8,000. Your capital gain tax rate is 20%. Now both stocks are at $10,000 each, and you need $10,000. Which stock will you sell - A or B?
Most investors will choose to sell Stock B, because they can't face the fact they will lose money if they sell Stock A!
However, that's not the most rational decision, because if you sell B, you will pay capital gain $400, so your after-tax cash will be only $9,600. If you sell A, you will incur $2,000 loss, which will generate $400 tax loss to offset your other income, so your net proceeds will be $10,400!
That's $800 difference!
What's your answer to the example above?
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