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The importance of investor behaviour

Written by Preet Banerjee

Friday, November 4th, 2016

There's an urban legend about an investment advisor who used to ask his new clients to fill out a completely unofficial form that simply had two boxes to choose from. One box was to be checked if the investor wanted to "buy low, sell high," and the other box if the investor wanted to "buy high, sell low." Everyone thought it was ridiculous: Who would ever want to buy high and sell low, thus losing money? Nonetheless, they were forced to fill out the form by ticking the box which represented the obvious choice (buy low, sell high).

Invariably, their investment portfolio would occasionally see short-term losses. During really volatile times, investors would become anxious, and some would call up the advisor in a huff, demanding the investments be sold for fear of further losses. Legend has it that if the advisor couldn't convince the investors to stick to their original, long-term investment plan, he would fax over that simple form they filled out initially. He'd ask them to cross out their original answer of "buy low, sell high" and put a tick in the "buy high, sell low" box, sign it, and fax it back in order for him to process their requests.

As you can imagine, it was expected that this farcical exercise might be just enough to convince some investors to continue holding course.

To be honest, if I were to go back to being an investment advisor, I would absolutely implement this silly little gimmick for all new clients. My experience has been that investors rely on short-term emotion more often than not, which leads to underperformance for investor portfolios.

How much underperformance?

A company called DALBAR, Inc. regularly releases a report known as the QAIB (Quantitative Analysis of Investor Behaviour). The 2016 report noted the average investor invested in US equity mutual funds experienced a 20-year annualized return of 4.67%, but that the benchmark index, the S&P 500, reported an annualized return of 8.19% during the exact same time period. In other words, investors lagged the market by 3.52%, annualized, over this 20-year period. The reason for the underperformance? Bad investor behaviour, most notably manifesting by trying to time the market.

That is a very big deal. If we had two investors starting with $10,000 earning those rates of return over 20 years, the difference would be over $23,000.

In the real world, an index investor looking to capture the market returns would lag the market slightly due to costs, so this gap would narrow, but even if you're an index investor, you won't escape the drag on returns due to behaviour.

No matter what kind of investment funds you use, active or passive, simply sitting on your hands once you've deployed your money into a portfolio has proven to be far more successful than making changes to your portfolio over time.

There's a funny old saying in the investing world that can help you remember the best strategy to follow once you've picked a prudent portfolio tailored to your personality and goals: Think of your portfolio like a bar of soap. The more you touch it, the smaller it gets.

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