Three reasons why your portfolio may underperform

Various factors may lead your portfolio to underperform in the overall market. Analysing the investors’ diminished returns, studies have found complex reasons, some that are well beyond investors’ control while others stemmed from investor’s own decision making. Here, we will look at 3 reasons why your investment portfolio could be underperforming and what you can do to avoid it.

There is no secret recipe for successful portfolio performance. To yield generous returns, one must adequately research their assets before investing in them and not succumb to distressful market situations. Unfortunately, that is a common occurrence in investors. A 2015 study on investor returns conducted by DALBAR found that the leading causes of diminished returns stem from investors’ own behaviour. These behaviour consists:

The reasons behind diminished return are consistent with research. We will focus on each of them and evaluate the steps that need to be taken to mitigate it.

1. Insufficient funds making your portfolio underperform

Typically, when there is a lack of funds to invest, it usually leads to the need for cash for other personal purposes. It takes money to make money; however, most people are barred from growing their financial portfolios due to capital shortage. Additionally, when you need money for personal emergencies, preventing your portfolios from underperforming will be the last on your priority list. It does not have to underperform - you can still invest with little capital while taking care of your personal reasons. The idea is not new, and it needs little changes here and there. But it does need consistency and discipline to make a significant impact on your performance.

Here are some strategies you can implement with your cash to access investment and cater to your needs:

  • Settle existing debts
  • Create an emergency fund
  • Finance your pension plan
  • Try out alternative investment platforms

Settle existing debts

It is difficult to invest any money if you have debt. It is a big obstacle for many people. Even if you invest, the earned profit will not be sufficient to pay the debt off. Therefore, your priority should be to be free of debts before investing. However, this does not apply to all sorts of debts. Debts that should be cleared first are ones with high-interest rates, such as credit cards. Other debts, such as low-interest debts and good debts (e.g. mortgage), are less daunting and do not pile up as quickly as credit card debts. In fact, these debts are necessary to build your credit scores in some countries. As these debts are generally of low interest, it is easier to pay them off while building a portfolio.

Create an emergency fund

Advice as old as time and still holds relevance to this day. This is the fund you will stash away for emergencies. Its purpose is to give you security for situations such as illness, unemployment, accidents and necessary purchases. Generally, it would be best if you had at least six months expenses, and it must be accessible at all times. You can start saving for an emergency fund from your salary and slowly build it up. You can put it in a regular savings account or a term deposit, depending on how likely will you need to access it.

Finance your pension plan

Investing in pension plans is an excellent strategy to save and invest for retirement and at the same time. Apart from state and employment pension, you can put a little of your savings into a voluntary pension to grow your money. Pensions can also be diversified between securities like stocks, bonds, mutual funds and other asset classes available globally. You will also get a basic exemption from tax up to a certain amount per year, which you should max out to get the most out of it. However, you must remember that early withdrawals will negate all the tax benefits, so you must stick to it to create value.

Try out alternative investment platforms

Many innovative digital investment services have been established to cater to a larger audience with little capital. These investment services explore larger asset markets and invest in a range of vehicles - real estate, consumer and business lending, cryptocurrency, crowdfunding and many others. Most of them require little capital to start investing, Quanloop being one of them (requires only 1 Euro to start investing) and are free to sign-up and use. They also usually have additional benefits, such as a secondary market to sell, referral income and bonuses.

2. Investment-related expenses

All investments not only carry risks but also carry costs. Unfortunately, many seem to ignore it as the amount appear too small in percentage.

Here are some of the examples of finance-related expenses you should get acquainted with.

Expense ratio

The expense ratio is a percentage based annual charge that you are paying to an investment advisor or manager to manage your fund. You could pay it to an active fund manager or to the platform itself, and it is billed on your annual return. For example, if your investment yields 10% and your expense ratio is 1%, you will actually earn 9% on return. What you really need to search is that the expense ratio remains low; otherwise, it will compound and eat a significant portion out of your profits. A 2017 study done by ESMA website over three years found that fees and one-off charges diminished returns by 29%. In Belgium, the diminishing returns amounted to up to 31% before inflation. Of course, the high fees mostly apply to actively managed funds (e.g. mutual funds). Passive investments require far less in fees and are more stable with returns. Regardless, a good ratio for fees should not exceed 0.2% per year.

Fees related to your investment advisor

Fees are mostly charged on the investment account itself and not the funds or the profits. Such fees include the yearly account fee, custodian fees, purchase and redemption fees and commissions if any. All or some may apply to your investment account. The problem is not the fee itself but the impact it can have if you are not observing. For example, if you invest 80,000 EUR in an S&P 500 index for a long term of 25 years, and your annual fee is only 0.5%, your growth will be up to 380,000 EUR on average. Now, add an annual fee of 2% to your index, and you will see your returns diminished to 260,000 EUR with you paying 120,000 EUR in fees. Since these fees appear really low, anyone might dismiss them. However, they will compound too and rise exponentially over time. Like expense ratio, your fees should be no more than 0.5% annually.

Taxes on investment

You need to be aware of taxes because you need to pay them before taking the profits. The suggestion is here not to look for lower rates because your taxes depend on your residency. Rather be observant of it and make your investment decisions around it. There are two types of taxes you should watch out for regarding your investment - income taxes and capital gains taxes:

  • Income taxes: Income taxes apply to the interests you have earned from your investments. Depending on the country, it can range from 15% to 55%. Estonia’s rate is 20% on interests of investments. Depending on the country, you may get the net interest with the investment platform paying it on your behalf, or you may receive the gross interest, and you have to declare it on your own.
  • Capital gains: Capital gains taxes are charged on the profit when you sell your investment assets. Some of the highest rates on capital gains are in Denmark at 42%, Finland and Ireland at 34% and 33%. Estonia charges the same 20% on capital gains. The lowest margin of capital gains tax is in Czech Republic, Greece, and Hungary at 15%. Here, you need to understand your state laws on taxation because not all countries in Europe tax capital gains, such as Belgium, Luxembourg, Slovakia, Slovenia, Switzerland, and Turkey. Having that knowledge helps you to understand whether you want to sell your investments at all and, if so, what time is most comfortable for your finances. However, to avoid any legal repercussions, it is best to get an advisor.

3. Voluntary behaviour due to psychological factors

Voluntary investor behaviour is the leading cause of portfolio underperformance. It stems from psychological triggers that make investors act irrationally. Some of them may sound familiar, for example, panic selling, buying high, poor allocation strategy and many more. The irrational behaviour is rooted in the lack of confidence in the market, which leads to your portfolio underperforming in the markets.

Five reasons lead investors to poor decision making:

  • Aversion to losses: Expecting high returns with low risk
  • Herd-mind: Copying others even when the circumstances are not in their favour
  • Naive diversification: Simply buying all of everything without understanding their risk and volatility characteristics
  • Anchoring: Trying to find a pattern, even when there is none
  • Media response: Making decisions based on anything the media says

Of course, the list is not exhaustive but more prominent than the others. In such situations, bringing your confidence back to the market should be the priority. The 2015 study by the DALBAR website suggested four practices to reduce irrational behaviour that you could consider in your decision making:

  • Set your expectations below the financial markets: It does not mean you should expect to lose anything. Rather, set reasonable expectations on returns and not be swayed by past performances or the media coverage
  • Control your risk exposure: You should not blindly diversify your portfolio by buying a piece of all assets. Instead, understand each asset’s risk and volatility before asset allocation to balance it out so that your portfolio is protected during the market crash.
  • Evaluate your risk tolerance: Market circumstances always change, so should your risk tolerance. Evaluate your risk tolerance periodically. Balance your goal to preserve holdings against wealth growth
  • Research your assets: Always look for credible information behind an asset before investing in it. Even though the market cannot be timed or predicted, it does not mean that there are no credible sources out there. Take them with a grain of salt and understand them because it will help you make a rational choice

By now, we are aware that trying to time the overall market, looking for patterns and not settling financial priorities harms you in the long term. The key purpose of discussing the behavioural roots behind portfolio underperformance is to help you understand wealth management and make good decisions. If you are still unsure of how to approach financial management, do not hesitate to consult an advisor. Implementing the suggestions may help you avoid portfolio underperformance in the long run.

Last update: 06/05/2021

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