Keeping Calm Means Better Returns on Investments
Back in May we told you to “keep calm in crap markets”. We likened good investing behavior to other efforts that are good for you, like keeping a healthy diet. In the same way that a diet can be de-railed when you’re emotional, so too can investing.
It gets hard to stick to a diet when you’re hungry or bored. It’s hard to stick to investing when the market heads south.
“Stick with it!” we said. It might feel good to react to the panic, but it’s bad for your end goal. Selling stocks when the market’s down is a sure way to lose money.
This sounds right in theory, but does it have real world implications? Turns out that it does.
We looked at our customer data from the past year. We were interested in the difference between set-and-forget investors and those who made changes during a particularly volatile period. We defined “a particularly volatile period” as the one we experienced starting in August last year (remember that?). It was an extremely difficult time for all investors. And we defined “set-and-forget investors” as those who did not change their allocation and automatic deposit settings during the volatile period.
We found that those who resisted making changes to their account between August and November in 2011 had a 1-year return that was 1.63% higher on average than those who changed both allocation and auto deposit settings. *
Admittedly, one year is a short time frame – too short to draw conclusions from, particularly when the average time to a goal at Betterment is 17 years. But even a 1.63% difference per year, if it holds constant, has a major impact.
Let’s take a hypothetical example and say we have 2 investors starting with $20K – a set and forget investor who doesn’t change his allocation or automatic deposit settings, and an investor who panics when the market falls and changes both settings at least 1 time per year. Let’s assume that annually, the “set-and-forget” investor earns an 8% return while the “panicking investor” earns 6.37% (for the above stated difference of 1.63% per year). Over 10 years the difference in their balances would be $6,091.51 – over 30% of their original investment!**
And it’s not just us. Countless other studies have demonstrated similar results. A study conducted by Cass Business School’s Centre for Asset Management Research in London in 2010 for Barclays, found that individual investors underperformed the buy and hold strategy by 1.2% per year. An earlier study of US mutual fund investors between 1984 and 1994 found that investors underperformed the buy and hold approach by 1.08%. These findings were echoed in a later study of mutual fund investors in 2007: The typical investor lost 1.56% per year due to market timing.
These figures are conservative when compared to a widely cited study by DalBar. According to the study, the gap between investors and the buy-and-hold data was as large as 10.65% in 1998 and 5.03% in 2009.
Our gut feeling is that customers reacting to the market are probably doing so out of anxiety – which is totally normal. In future volatility however, we hope you can look to these results on the performance gap as a way to stick with your plan. It will help you reach your goal faster.
As for active trading – turns out that those who experience extraordinary returns are merely lucky. We go into detail in this post – Active Trading: Skill or Luck?
* Data above based on the performance of all Betterment customers who were investing with Betterment, had automatic deposits enabled prior to August 1, 2011, and maintained an active account through August 1, 2012. The 1 year return period for these customers was August 1, 2011 to August 1, 2012 (“return period”). These customers were segmented into 2 groups: “set-and-forget investors” were defined as customers who did not change their asset allocation or automatic deposit settings during the period from August 1, 2011 to November 1, 2011 (“the volatile period”), and “investors who made changes” were defined as customers who changed both their asset allocation and automatic deposit settings during the volatile period. During the return period, the returns for the first group were 1.63% higher than the returns for the second group. These customers were invested in Betterment’s recommended portfolios following Betterment’s advice. Measured returns reflect the deduction of investment advisory fees and the reinvestment of dividends.
The current recommended Betterment portfolios can be found on our investments page.
Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Past results are no guarantee of future returns.
Please consult the Investment Tools and Model Predictions section of our terms and conditions for further information regarding Betterment’s advice and these performance results.
**The scenario outlined is just an example. It does not reflect actual or expected returns of individual investors nor any market data nor Betterment’s investment methodology or results. Statistics cited are solely for explanatory purposes. The chart shown is based on a $20,000 beginning investment with annually compounded returns of 8% and 6.37% each year for 10 years with no subsequent investment.
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