At Barclays, our experience of behavioural finance gives us insight into two aspects of investor behaviour that the industry would have a hard time understanding without it.
Residents of the United States, please read this important information before proceeding
The first is reluctance: individuals often fail to see the potential long-term benefit of investing in a diversified portfolio compared to holding cash. This can cost the average investor 4–5% per year of foregone returns, over the long term. Figure 1 shows the effect of sitting in cash versus investing, over the last 10 years. Even during this turbulent time in the markets, being invested was a clear winner. Indeed, it’s only in the depths of the most extreme crisis in living memory that a diversified portfolio dipped below cash, and as long as the investor didn’t sell in panic, this situation was very short-lived.
Figure 1: The long-term value of diversified investing
Source: FactSet, Bloomberg, Merrill Lynch and Barclays. Past performance is no guarantee of future results. The Diversified Portfolio, representing nine asset classes, is constructed as the following mix of indices: 7% Barclays US Treasury Bills Index; 4% Barclays Global Treasury Index; Investment Grade Bonds 7% Merrill Lynch Global Broad Market Corporate Index; 11% Merrill Lynch Global High Yield and Emerging Markets Index; 38% MSCI World Index; 10% MSCI EM Index; 5% Dow Jones UBS Commodity Index; 4% – FTSE EPRA/NAREIT Developed Global REITs Index; 14% HFRX. The weightings are rebalanced monthly to maintain the same mix over time. An investment cannot be made directly in an index.
The returns depicted above do not represent actual portfolios, nor do they reflect trading or the impact of material economic and market factors including fees. Hypothetical illustrations and performance have certain inherent limitations. No representation is being made that any client will or is likely to achieve the hypothetical return represented in the illustration on this page.
The second issue that behavioural finance sheds light on is the behaviour gap. Multiple studies have confirmed that the average investor underperforms a simple buy-and-hold strategy over long periods of time. Most credible research on individual (as opposed to institutional) investors finds this under-performance to be between 1% and 2% per year, on average (although this can be substantially higher). And the behaviour gap is purely attributable to market-timing decisions, not costs or fees.
It’s only in the depths of the most extreme crisis in living memory that a diversified portfolio dipped below cash
Estimating the behaviour gap
The behaviour gap describes the difference between actual investor returns and the returns an investor might have achieved had they doggedly adhered to classical principles.
A recent study by Cass Business School – which used data from investors in actively managed UK equity funds over a 20-year period – concluded that, relative to a buy-and-hold strategy, the average investor conceded 1.2% annually by moving in and out of funds. This percentage may not sound like much, but it amounts to a significant difference in final wealth when compounded over 20 years.
In the example below, we take the Cass study’s behaviour gap of 1.2% annually – many other studies have found investor behaviour gaps to be substantially higher – and apply it to a hypothetical Diversified Portfolio. An investor who invested $1mm in a moderate-risk diversified portfolio would have $4.44mm after 20 years.
A behaviour gap of 1.2% per year would, over two decades, reduce this to $3.50mm, a difference of $940K or 21%.
Figure 2: The long-term impact of the behaviour gap
Source: DataStream and FactSet. Study commissioned by Barclays at Cass Business School, Clare & Motson (2010). “Do UK retail investors buy at the top and sell at the bottom?”; UK equity funds from 1992 to 2009 recorded by the Investment Management Association. Past performance is no guarantee of future results.
The Diversified Portfolio is represented as the following mix of indices, all in US dollars: 7% - Barclays US Treasury Bill; 4% - Barclays Global Treasury; 7% - Barclays US Corporate Investment Grade (1 Jan 1992–31 Dec 1996), then Merrill Lynch Global Broad Market (1 Jan 1997–31 Dec 2012; 11% Merrill Lynch USD High Yield & Emerging Market Sovereigns (1 Jan 1992–31 Dec 1998), then Merrill Lynch Global High Yield and Emerging Markets (1 Jan 1999–31 Dec 2012); 38% - MSCI World Index; 10% - MSCI EM Index; 5% - Dow Jones UBS Commodity TR; 4% - Real Estate by FTSE EPRA/NAREIT; 14% - HFRI fund of Funds Composite (1 Jan 1992–31 Dec 1997), then HFRX Global Hedge Fund (1 Jan 1998–31 Dec 2012). The weightings are rebalanced monthly to maintain the same mix over time. Changes in indices were made based on availability of historical index data.
The returns depicted for the hypothetical Diversified Portfolio above do not represent actual portfolios, nor do they reflect trading or the impact of material economic and market factors including fees. Hypothetical illustrations and performance have certain inherent limitations. No representation is being made that any client will or is likely to achieve the hypothetical return represented in the illustration on this page.
It is important to note that the Cass study’s behaviour gap is an average: Some investors did better, but some did worse. For a first-time investor who entered the equity markets in a state of emotionally charged enthusiasm at the peak in November 2007, and later sold in terror at the beginning of March 2009, a mere 1.2% behaviour gap would have been extremely soothing.
Assuming this investor had put everything into the MSCI World index, his or her return would have been -54% in 16 months, before costs!