Strategy for consistent performance is often most difficult one to adopt

In 2020, the share price of Zoom Technologies Inc. (ZTNO) rose to $20.90 on March 20 from $1.10 on Jan. 1. On Nov. 12 of that same year, the price dropped to a mere 16 cents per share. Investors who bought the stock and pushed the price higher probably thought they were buying the video conferencing platform that became notoriously popular for virtual meetings during the Covid-19 pandemic. ZTNO investors relied on representativeness, assuming the name coupled with the price explosion confirmed they were investing in the right business. However, Zoom Video Communications Inc. (ZM) and ZTNO are entirely different entities.

It’s easy to be overconfident in our ability to beat the market. Overconfidence is the common experience of overestimating our understanding and skill, and underestimating potentially adverse outcomes.

However, studies repeatedly demonstrate that most active investors, including professionals, fail to outperform the broad index over long periods. Yet, we are beguiled by stories of wild success and quick profits, as well as our innate enthusiasm for the investment decision we are about to launch.

Behavioural biases influence financial choices more than you may expect. We often rely on familiarity or recent experiences more heavily than we would like to believe. For example, plausible news reports in this morning’s social media feed may set the tone for trades you make that day. And after experiencing a loss, you may be unwilling to invest in similar investments, even when they provide an excellent opportunity in the future or advantageous diversification within your investment portfolio.

You may also find you favour certain stocks because of past performance, familiarity with those businesses, the countries where they are listed, or because they sell products you regularly use. And a company’s surprise earnings report or an extended period of stock market volatility influences investors to think that more of the same lies ahead.

Each of these common reactions interacts to push your choices toward an outcome that may not be arrived at as independently as you think. The ultimate effect of this interference is a suboptimal return on investment.

In fact, about half of all investors experience below-average performance. That’s a mathematical reality. If your investment experience falls in this category, you could quickly remedy poor performance by investing in the broad market or ETFs that track the returns of a specific index, such as the S&P 500 in the United States or the S&P/TSX composite in Canada. Yet, many investors are reluctant to reap the long-term benefits of passive investing because of the fear of missing out and other behavioural influences, even when a passive strategy eliminates the risk of underperformance and lowers the stress associated with active investment management.

While a passive strategy can reduce the impact of behavioural biases, it’s not without challenges. One of the most significant tests is overcoming the temptation to deviate from index investing when faced with short-term market volatility or the fear of missing out on greater gains.

When market values decline, passive investors may feel regret, compelling them to act — often deviating from a sound investment strategy at the wrong time. Conversely, when the market is performing well and you’re bombarded with stories from friends and media about quick profits and excessive gains, you may be tempted to switch to active strategies, jumping into security selection to replicate the excitement of fast money. Too often, investors are enticed to select stocks or strategies that other speculators have already driven up in price. The higher the price, the lower the potential profit and the greater the risk.

More commonly, after a prolonged period of broad market growth, passive investors may become overconfident in their ability to beat the market, especially if they have followed certain stocks that have risen more than the index. This phenomenon is related to hindsight bias, where you are left with feelings of regret about past decisions, and it often leads to making changes after the event has happened.

Despite these challenges, passive investing has a proven long-term track record. It provides broad diversification among various companies, reducing the risk associated with individual positions. Diversification reduces the volatility of holding only a few stocks or having limited exposure.

Every year, SPIVA (S&P Indices Versus Active) compiles data on the performance of actively managed investment funds. Most equity funds underperform the S&P/TSX composite and the S&P 500, and over five-year periods, more than 95% of funds fail to meet index returns every calendar year. Over the long run, passive investing more consistently outperforms active strategies.

With lower fees, more consistent outcomes, less required time and lower stress, passive investing is a compelling alternative. The trick is to stick to it. Implementing a passive investment strategy requires discipline and a long-term perspective. It’s essential to stay focused on your goals, educate yourself about the benefits, and seek professional advice when needed. By doing so, you can overcome the challenges posed by behavioural biases and achieve your financial goals.