Individual Investors: Incurring Frictional Costs and Fighting Behavioral Bias

When thinking about a portfolio’s financial returns, they are typically benchmarked against the general market and broad index funds such as the S&P for equity portfolios. The ability to generate excess returns against the market’s performance (i.e., the ability to generate “Alpha”) is one of the key reasons investors actively manage their portfolios.

However, the average investor consistently underperforms the market. SPY, the S&P 500 index ETF, had an annual return of 6.87% for the 10 years ended 2016. Over the same time period, the average diversified equity fund returned 5.15%, but the average U.S. investor in diversified equity funds only enjoyed a 4.36% return per Morningstar. That means $100,000 invested at the beginning of 2007 would grow to the following balances by the end of 2016:

This means the average investor underperforms an S&P ETF by ~$41,000 and underperforms the equity funds they invest in by ~$12,000. So why are individual investor returns so much lower? 

First of all, the odds are stacked against individual investors when benchmarking against index funds. Investors are always incurring “frictional costs” – trading costs, loads, commissions and capital gains taxes – all of which must be paid when they move in, out, or within a fund or portfolio. Investors even incur frictional costs while they’re simply holding the stocks in the form of management fees and account fees. 

However, while fees certainly contribute to the gap, the biggest obstacle that investors have to overcome is themselves. Per Dalbar, a Massachusetts research firm that has been studying the behavior of mutual fund investors, “the retention rate data for equity, fixed-income and asset-allocation mutual funds strongly suggests that investors lack the patience and long-term vision to stay invested in any one fund for much more than four years. Jumping into and out of investments every few years is not a prudent strategy because investors are simply unable to correctly time when to make such moves.” Human behavioral biases lead to irrational investment decision making and leads individual investors to buy high and sell low.

No individual investor likes to hear this. Each investor thinks that even though “individual investors” as a group don’t perform well, and they know the statistics are accurate, they believe they themselves are the exception, due to their experience, intelligence, financial savvy, etc. However, the numbers don’t lie: behavioral coaching from advisors generates the most returns (1.5%) for clients, based on Vanguard research.

So what can individual investors do to de-risk their portfolios despite the mechanical and psychological headwinds they face? This is where the discipline, knowledge, and experience of a financial advisor can add tremendous value.

ROI of a Financial Advisor: Increase Annual Net Returns by 3%

While working with an advisor incurs fees, financial advisors employ many strategies and best practices to increase net returns (returns net of fees) to their clients. The 7 main ways advisors provide value to their clients have been quantified by Vanguard to increase annual net returns for their clients by ~3%.

To put this number into context, a 3% increase in the annual returns of the previously mentioned average equity investor would equate to a total balance of $203,434.70 at the end of the 10 year holding period ending in 2016, a ~$50,000 increase when compared to the investors’ individual returns. Half of this increase in returns is directly attributable to coaching individuals to behave rationally during times of market volatility.

The Other Input: Your Time

One other input to consider is your time, as the overall amount and types of assets you manage across your investment portfolio increase, the more regular housekeeping and research you’ll have to do to continue optimizing for costs, timing, and strategies. Below are some of the key services that an experienced financial advisor can manage for you, or do most of the heavy lifting for in order to guide you in your decision-making process.

Asset Allocation

A portfolio’s asset allocation and diversification are two of the most important determinants of return variability and long-term performance. A financial advisor can optimize your asset allocation based on your financial situation, risk tolerance, investment time horizon, and financial objectives, creating a portfolio with risk and return preferences that are unique to your profile, while also taking into account your planned expenditures and annual contributions.

Also, optimizing where the assets are held helps minimize eventual tax liabilities by holding tax-efficient investments in taxable accounts and by holding income generating, taxable investments within tax-advantaged accounts. The effects are incremental but compound to make a meaningful difference over time, particularly for retirement accounts. 

Cost-effective Implementation

As an investor, you only get to keep, spend, or bequest net returns (gross returns less frictional costs). Therefore, the goal should always be to maximize net returns for a certain risk profile. Cost-effective implementation maximizes net returns by minimizing frictional costs such as management fees, trading costs, and tax. The average investor does not have the time, effort, or expertise to evaluate, benchmark, and control these costs rigorously, but a good financial advisor does. 

Rebalancing Regularly

As your portfolio’s investments produce different returns over time, they will likely drift from their original target allocation, acquiring new risk and return characteristics that may be inconsistent with your original financial objectives. A good advisor will direct your cash flows into the most underweighted asset class, reducing your rebalancing costs on a regular basis. 

Behavioral Coaching

The most important service a financial advisor can provide is behavioral coaching. Emotional investing based on herd mentality or fear is one of the main reasons why individual investors underperform not only the general market, but also the funds that they invest in, often buying during highs and selling off during lows.

A trustworthy advisor who develops deep relationships with their clients can help you maintain a planned investment strategy during a difficult market so you don’t miss out on the upside. Alternatively, an advisor may encourage you to partially sell out of an investment that has outperformed so that you can lock in those gains. This directs the focus away from recency bias in investing and focuses on the appropriate investment time horizon.

Strategic Tax Planning

Just as asset location is important when you’re making investments, a proper withdrawal strategy when you begin to spend your portfolio can also have a powerful impact on your tax consequences.  For example, pulling funds from a traditional IRA before the age of 59 ½ or failing to take out the required minimum distribution after the age of 72 will both result in significant tax penalties. A good financial advisor will consider tax liability as part of your overall investment strategy.

Total Return vs. Income Investing

Historically, some investors may have been able to live comfortably off of their stock dividends and/or interest payments from their bond portfolios. However, interest rates and dividend yields have fallen in recent years, making this income investing approach less effective. A total return approach considers both capital appreciation and income investing. An advisor can take this approach to tailor your portfolio to meet your individual needs.

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