Closing the Retail Investor Performance Gap
It is pretty well documented that the average retail stock market investor does not obtain the same long-term results as the broad market indexes. Here is a link to just one article titled, “Why Average Investors Earn Below Average Market Returns,” that discusses why retail stock investors do not replicate long term market returns. The stat provided in this article is that the annual return of the S&P 500 index for the 20-year period ending on 12/31/2015 is 9.85%. However, the average equity fund investor’s annual return for this same 20-year period is only 5.19%. I think this article, similar to many others like it, is correct when they point out that when it comes to investing, the average investor’s own emotions are their biggest obstacle to success.
What made me think about this topic was I had just completed my 2018 tax return. In 2018 I had sold a rental property that I had owned for about 20 years. In collecting the historical data on this property sale to complete my taxes, I decided to see what kind of investment return I actually got from owning this property all those years. The results showed my investment did pretty well, so I decided to research how well I had done with my long-term financial investments. Even though I consider myself a pretty knowledgeable investor, my results show that I also underperformed the broad index. I will provide my results below and some thoughts about why this happened.
I broke down my long-term investments into three categories:
- The rental property I had just sold in 2018,
- My financial assets held in a long-term taxable retirement account,
- My financial assets held in tax-deferred retirement accounts,
I compiled data to compute the average annual return of these three assets for the most recent long-term period that was easy to determine. For the financial assets, the period was the years from June 2001 through May 2019 as my taxable investment account has only been open for this period. For easy comparison I used the same 18-year period for my tax-deferred retirement accounts even though they have been open much longer.
The table below shows my average annual return over the time periods listed above for these 3 assets. I have also included the 20-year average annual return of the S&P 500 index from May 1999 to May 2019 for comparison to a broad stock index.
| 18 or 20-year Average annual Return | S&P 500 index | Real Estate Investment property | Taxable Stock Investment Account (80% equity allocation) | Tax-deferred IRAs (50% equity allocation) |
| Return from Capital Gains | 5.2% | 9.6% | 2.5% | 1.9% |
| Return from Income | 2.3% | 4.9% | 2.8% | 1.2% |
| Total Return | 7.5% | 14.5% | 5.3% | 3.1% |
NOTE: All returns are net of any management fees. All figures are before taxes.
As I said previously my stock market returns are lower than the broad S&P 500 index. However, some clarifications are needed. The S&P 500 index returns assume that you have 100% of your assets invested in the index. My investment accounts have never had 100% invested in stocks. I have noted in the table my estimated average equity allocation in both accounts for their respective time periods.
In the table below I have estimated what my annual returns might have been had I allocated 100% of my assets to the stocks/mutual funds I chose over the years. I increased the capital gains returns by a factor as if all funds were invested in stocks (i.e., 25% and 100%). These new estimated annual returns can now be more directly compared to the S&P 500 index.
| Estimated Average 18-year annual Return | Taxable Stock Investment Account (100% equity allocation) | Tax-deferred IRAs (100% equity allocation) |
| Return from Capital Gains | 3.1% | 3.8% |
| Return from Income | 2.8% | 1.2% |
| Total | 5.9% | 5.0% |
Investment Conclusions
Even after increasing my returns to allow for my lower equity allocations, I still have a stock market performance gap just like most retail investors. I was about 1.6% below the broad market in my taxable investment account and over 2.0% below the index in my tax-deferred accounts. I spent a lot of time thinking about why this might be.
There could be a lot of reasons for my performance gap. Did I choose stocks or index funds that underperformed the S&P 500 index over this period? This is definitely true in my tax-deferred accounts. To incorporate diversification, I had allocated significant amounts to emerging market and small-cap equities. These indexes have not performed nearly as well as large-cap stocks, especially large-cap growth stocks. However, over the years in my taxable account, I have owned almost 100% dividend-paying large-cap stocks. But this account also underperformed the broad index, albeit by less. I should also point that, because I had a significant allocation to cash and fixed income investments, I did not do any panic selling during the 2008-2009 financial crisis. I, in fact, re-balanced my retirement accounts and bought more equities during this period when equity prices were depressed. Despite doing this, I still underperformed the broad stock market.
The real estate investment return really jumps out as this return is much higher than the broad stock index. Why did the real estate investment do so much better? Well, one reason is the real estate investment was leveraged with a mortgage note. My down payment was only 20% at purchase, so my 14.5% annual return is not based on the purchase price, it is based on the amount I personally had invested in the property. This invested amount, after including all the capital upgrades over the years, was less than half the original purchase price.
After much review of my financial account data, I saw one figure in my “tax-deferred” accounts that really stood out. My IRA brokerage keeps a tally of how much money goes into and out of the account. This figure tells me, roughly, the total of how many dollars I used to buy and sell investments (i.e., moving assets between investments). A quick calculation indicated that, over 18 years, I had been buying and selling an average of almost one-third of my account balance EVERY YEAR. This really surprised me as I did not do any “trading.” But, obviously, over the course of a given year I would move funds around to different assets more than I realized.
After discovering this, I went through my 18 years of annual statements of my “taxable account” and discovered, although much less, I still had a fair amount of trading volume. And I noticed most of this trading volume occurred in the period from 2001 to 2009. I decided to calculate the return in my taxable account for the two periods from 2001 to 2009 and then again for 2009 to 2019. My return from 2001 to 2009 was actually slightly negative for the entire period. However, my average annual return for the period from 2009 to 2019 was closer to the broad index, 12.4% versus 13.7% for the S&P 500 index. I was still lower, but the percentage difference was much smaller for this period. After performing this calculation, it dawned on me what the problem was. In my taxable account from 2001 to 2009 I had very little capital gains, so I did not think twice about selling a stock. In the most recent 10 years, when the market seemed to rise every year, I had a lot of capital gains. I only occasionally trimmed my stock holdings in 2012 to 2019 to “re-balance” my overall portfolio. I believe this is why my average return the last 10 years is much closer to the index return as compared to the 1st eight years. I did much less selling in my taxable account from 2009 to 2019 because of the significant capital gains tax I would incur.
Applying this realization to my tax-deferred accounts, it was obvious the same thing had occurred, but to an even greater extent. Because there are no tax implications when you sell a stock or mutual fund in an IRA, I did a lot more selling (and, subsequently, more buying) in these accounts. Even though I had a lot of funds in lower performing indexes, I am certain this selling and buying hurt my returns over the years. But why did I do so much selling as my 50% equity allocation did not change very much. In my case I think I sold more often due to “over-analysis” of the market, which in affect meant I was trying to time the different stock sectors. In any case, if you are a long-term investor, it is clear that doing a lot of buying and selling is not helpful to your returns.
What really convinced me that too much buying and selling was a problem in my financial accounts was my real estate investment. By its very nature real estate investments cannot be traded (at least not very easily and not without major costs). Even though my investment property returns were helped via leverage, I am sure that being unable to buy and sell pieces of the property and just leaving it alone for 20-years through all the market ups-and-downs, I did much better than I would have otherwise.
To summarize, my personal investment analysis does not add any new light to investing. It just reinforces the age-old advice that trying to time the equity markets by being “all-in” or “all-out” (or in my case trying to time different market sectors) at the right time is a fool’s game. Even the experts on Wall Street do not know what the markets will do at any time. As I write in my book, it is best to just determine your appropriate equity allocation based on their personal risk tolerance and stick with it regardless of what the markets are doing. Then, if it strays too far off, periodically “re-balance” your portfolio back to your chosen equity allocation. Resist the temptation to sell when the stock market takes a big drop. The market will always recover. The only question is when.
Even if you are nearing retirement, you still should not sell your equities if we suddenly experience a big market down draft. You should already have set your equity allocation at the appropriate percentage for where you are in life. For example, I am 64 years old and my equity allocation is currently set at 30%. If the stock market crashes later this year, I will buy more stocks and re-balance my portfolio back to my target equity allocation of 30%. A good guide for choosing your equity allocation is the formula:
Equity allocation % = 100% – your age.
Finally, if the opportunity arises to pick up a good investment property at the right price, consider doing this as well. Just remember to hold it for the long-term.
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