Heads I win, tails I don’t lose

Having worked for more than a decade in wealth management, I find retail investors fascinating. Talking to them is like doing your own little behavioural finance experiment every day. And one thing that you get to learn when dealing with retail investors is that most of them are supremely confident in their abilities as investors – especially if they are wealthy and have been successful as entrepreneurs or in their careers.

So, it doesn’t surprise me at all that in a study of 771 US retail investors who had experience investing in stocks and other assets, the ones that were able to select their own portfolio of stocks expected it to outperform the index. To be precise, the investors were given a hypothetical sum of $40,000 to invest. One half of the participants could select a portfolio based on the 30 stocks in the Dow Jones Industrial Average, while the other half were assigned a portfolio of an ETF on the index or a random selection of stocks from the index. The investors who could select the stocks themselves expected their portfolio to outperform, while the ones who were assigned an ETF or a random selection of stocks did not.

That’s the boring part of the experiment. The interesting part is what happened when the retail investors were asked how much their portfolio would gain if the Dow went up 5% or 10% and how much their portfolio would lose if the Dow lost 5% or 10%. The answers they gave are plotted below and are revealing.

Expected gains and losses of retail portfolios vs. the market

Source: Merkle and Ungeheuer (2021)

When the market rises, investors typically expect their portfolios to rise in tandem (i.e. a beta of 1), but when the market drops, they expected their portfolios to drop less (the beta for losses is c.0.8). Only the investors who were assigned an ETF that tracks the index understood that if the market drops 10% they will lose 10% as well.

Meanwhile, even those investors who were randomly assigned a bunch of stocks thought they would outperform in a correction. And the ones who selected the stocks themselves, thought, they would lose even less in a correction.

To me, this reflects an attitude that I have seen so often with retail investors. When markets go down and they lose money they think they could have done a better job if they had managed their portfolios themselves. But when they are being sold a fund, then they expect the active fund to outperform the market in a correction or bear market, otherwise, the fund manager has not done his or her job. If their investment portfolios don’t meet these expectations, you can be assured that your investors will ask you some tough questions.