Do You Actually Know Your Portfolio's Returns? Many Don't

(MoneyWatch)  Even smart people make mistakes. However, they learn from them and don't repeat them. Unfortunately, the evidence suggests that investors generally don't learn from experience, and they keep making the same mistakes. One reason may be because they don't know they're making mistakes. Two interesting studies illustrate this point.

William Goetzmann and Nadav Peles surveyed a group of investors belonging to the American Association of Individual Investors (AAII) and a group of architects about their retirement plan investment returns. AAII investors are presumably knowledgeable about investing, yet they overestimated their prior year performance by 3.4 percent. Architects are intelligent, though they may not be knowledgeable investors. They overestimated their return by 8.6 percent. Both groups were also asked about their performance relative to a benchmark made up of the same asset allocation. The groups overestimated their relative performance by 5.1 and 4.2 percent, respectively.

Markus Glaser and Martin Weber found similar evidence after analyzing the performance of online brokerage accounts of individual investors. They compared the actual results to the answers the investors provided on a questionnaire. They found that:

• Only 30 percent considered themselves to be average.
• Investors overestimated their own performance by 11.5 percent a year.
• The lower the returns, the worse investors were when judging their realized returns.
• While just 5 percent believed they had experienced negative returns, the reality was that 25 percent did so.
• On average, investors underperformed relevant benchmarks. While the arithmetic average monthly return of the benchmark was 2.0 percent, the mean gross monthly return of investors was just 0.5 percent, and more than 75 percent of investors underperformed.

How do we explain the disparity between reality and perception? When the reality is too painful we adjust our memories. It's called cognitive dissonance.

About this time, you should be asking yourself the following questions: "Do I know my rate of return? How does it compare to the return of appropriate benchmarks?" The typical investor is unlikely to have the correct answers. And that's not a good thing because it's impossible to judge the success of a strategy without knowing the answers to those questions.