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How to Not Consistently Beat the Market

The investing dog chasing returns still can’t catch its own tail.

According to Dalbar’s 2014 Quantitative Analysis of Investor Behavior (QAIB), average investor returns continue to lag market returns. The shortfall is a result of bad investor behavior from buying investments that are high and selling those that are low — also known as chasing returns.

The study shows that over a 20-year period, the return of the S&P 500 was 9.22% while the average investor saw a return of 5.02%. Like a broken record, a gap between market and investor performance has been shown in every annual QAIB since the first study in 1994.

The consistent underperformance from chasing returns is strong evidence of investor susceptibility to recency bias. A popular topic among behavioral finance circles, recency bias is the tendency to think the market will act the same in the future as it has in the recent past. In other words, investors are compelled to make investment decisions based on emotions like greed and fear.

Further exploring this tendency is YiLi Chien, senior economist at the Federal Reserve Bank of St. Louis. Using data from 2000-2012, Chien found a positive correlation between U.S. stock mutual fund cash flows and previous quarter returns.

While it seems like common sense to buy what is performing well and avoid what isn’t, doing so may end up costing investors in the long run. Chien compared the returns of a return-chasing strategy with a buy-and-hold strategy. According to his analysis, the return-chasing behavior would produce a 3.6% average annual return, 2% lower than the 5.6% realized by the buy-and-hold strategy.

Therefore, investors making investment decisions on short-term trends end up doing exactly what not to do to beat the market – they buy high and sell low, which can produce returns lower than doing nothing at all.

Another way to not consistently beat the market is by not even trying to beat the market. Consider index funds, which aim to match rather than beat the specific indexes they track. They attempt to generate the same returns as their benchmark. While investors with a portfolio of all index funds may not consistently beat the market, they may have a higher probability of meeting their investment goals. (Isn’t that what matters anyways?)

For instance, in an updated study, entitled The Case for Index-Fund Investing, Vanguard demonstrates that low-cost index funds have shown a greater probability to outperform higher-cost actively managed funds.

By chasing short-term market trends, investors typically not only fail to beat the market, but also surrender their potential to capture long-term returns. That’s why attempts to consistently beat the market are misguided in the first place.

As Charlie Munger once said, “Practice ‘sit on your ass investing.’ You’re paying less to brokers, you’re listening to less nonsense, and paying less in taxes.”