We all like to have a high opinion of ourselves and it is part of the human condition that we have a tendency to seeing ourselves as above-average (this is also called the illusory superiority bias and is a cognitive error we all make). And this is probably also true when it comes to investing.
The chart below, however, indicates that this really isn't the case and it gives us all a much needed reality check: The average investor is well below-average when it comes to achieving investing success.
The following presentation slide from Nuveen Asset Management compares the 20-year annualized returns from 1992-2011 for a variety of asset classes.
Real estate investment trusts, for instance, gained 10.9% annually each year, the most of any asset class, while the S&P 500, a major benchmark index, returned 7.8% on an annual basis.
Asset class returns ranging from REITs to oil and bond investments were ultimately compared to the return the 'average investor' achieved over the 20 year period and results aren't pretty: The average investor gained a mere 2.1% a year thereby hugely underperforming all other asset classes.
Passive investment strategies are superior
There is an important implication here for the average retail investor: If they invested their money in an S&P 500 index fund or an exchange traded fund that tracks the performance of the S&P 500, they would have achieved fundamentally better investment returns compared to what they actually earned. Let's be honest: A return of 2.1% per year is pretty bad.
This is a big thing to notice for investors: Instead of trading in and out of positions and chasing market returns, investors would have done much better by resorting to an investing method called indexing.
Indexing basically means investors can purchase an index fund or an exchange traded fund that mimics the performance of an underlying index such as the S&P 500 at very low costs.
Exchange traded funds are traded on the stock exchange just like any other security and can be bought and sold during regular trading hours.
What about inflation?
The chart above has yet made another depressing revelation: The average investor was unable to earn the inflation rate. This is a big no-no when it comes to investing and clearly is a big disappointment.
Over time, increasing prices in an economy decrease the purchasing power of consumers. As investors we would want to at least earn the inflation rate in order to make sure that our living standard is not being eroded.
Reasons for underperformance
Why is it that the average investor achieved such dismal performance results?
Average investors often display herding behavior: They buy stocks when everybody else does and similarly avoid the stock market when nobody wants to buy stocks anymore. This 'herd following mentality' is not necessarily beneficial for investors' investment returns.
Remember Warren Buffett's old adage: "Be greedy when others are fearful and fearful when others are greedy." This is excellent investment advice and it should be your guiding investment principle.
The Foolish Bottom Line
Understand that typical investors have a tendency to buy stocks at the peak and to sell at the bottom.
Passive investment strategies such as buying an index fund or an exchange traded fund are valid alternatives to active management and, over the long-term, achieve quite respectable results.
Achieving a return larger than the inflation rate is paramount in order to protect your purchasing power, which should be a key investment goal for every investor.