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April 25, 2017

What are the true returns of the average investor?

Most investors cannot tell how well their own portfolio has performed over time. This year, the first broad based research report was published about the performance of German retail investors. The analysis of nearly 40,000 accounts makes for grim reading: over a 10 year period, the average return was only 3.1% p.a., lagging behind a risk-adjusted market portfolio that compounded at 8.7%. A 5.6% annual performance gap is evidence that Do-It-Yourself does not work for most investors. The picture is similar in other countries. In the US, investors have underperformed by around 3-4% p.a over the long-term (Dalbar study).

Investors are their own worst enemy

Two accademics, Andreas Hackethal and Steffen Meyer, analyzed nearly 40,000 accounts from 2005 to 20015 among various German online banks. The results are pretty shocking: despite a surprisingly high equity/bond mix of 80/20, the average investor achieved only an annual return of 3.1%. An comparable index would have delivered an annual return of 8.7% over the same time frame.

To put this into context, an initial investment of  €100,000 at a 3.1% return would have turned into €135,702 after 10 years. At 8.7%, it would have turned into €230,301. The gap becomes even more staggering after 20 years when investors would have received €184,151 or €530,385 respectively. Can you afford to ‘lose’ so much money?

The main reason for the return shortfall was poor stock-picking. This shouldn’t really be a surprise. Even professional investors are struggling to beat an index over time. It is difficult to understand why individual investors believe they can beat the professionals at their own game.

Typical investor mistakes

We often see that investors make the following three mistakes:

  1. Lack of diversification. Why take unnecessary risks? As the saying goes, don’t put all your eggs in one basket. But the average account had only 12 stocks. You need at the very least 100, if not thousands of stocks to diversify away the idiosyncratic risk. As an individual investor, it is impossible to follow that many stocks. Put differently, broad diversification is for those investors who do not have a clear crystal ball – which is everybody.
  2. Overtrading. The research note proved again that accounts that trade more had worse results. To quote Warren Buffet, “inactivity strikes us as intelligent behavior” and “lethargy bordering on sloth remains the cornerstone of our investment style“. Don’t overtrade. Most investors would be better off if they pick an investment, come back once or twice a year at most for a check-up. In the short run, hares have more fun; but in the long run, it’s the tortoises who win the race.
  3. Home bias. Individual investors tend to buy what they know best. It is therefore no surprise that 43% of the stocks in the accounts of German retail investors were German based companies. However, Germany accounts for less than 5% of global GDP. It isn’t just the population that is getting older in Germany, the same is true for stocks here too. The youngest company in the German index DAX is the enterprise software business SAP – and it was founded nearly 50 years ago. Unfortunately there is a lack of high-growth tech, pharma and biotech companies in Germany. Compare this with the US, where three of the largest companies (Amazon, Google, Facebook) did not even exist 25 years ago. By investing globally, you automatically gain exposure to different industries and thus improve the risk/return profile of your portfolio.

Conclusion

The bottom line is that both theory and historical evidence demonstrate that individual investors fall far short of their potential. If you would like to know how we can help you reach your goals, don’t hesitate to get in touch.