It is widely accepted that ordinary investors underperform both professional investors and market benchmarks. The most common explanation is that people let their emotions get the better of them, resulting in a perverse "buy high, sell low" investment cycle, but the biggest problem may be an altogether simpler one – investors simply hold too much cash.

Globally, cash allocations among retail investors averaged 40 per cent in 2014 and 31 per cent in 2012, according to State Street surveys that examined asset allocation in 16 countries.

These extraordinarily high cash allocations might indicate that investors were still traumatised from the brutal 2008- 2009 global financial crash, although it should be noted that high cash allocations are a constant among retail investors.

According to American Association of Individual Investors data, cash allocations have averaged 24 per cent over the last three decades. In contrast, professional money managers typically keep cash allocations of roughly 3 to 5 per cent.

Given that equities almost invariably trounce cash over the long term, it is a given that ordinary investors must therefore underperform their fully invested professional counterparts.

Emergency cash fund

There are good reasons why ordinary investors hold higher cash allocations. In an ideal world, investors would allow their investments to multiply over many decades, but the reality is that most people may need to access their savings for all kinds of reasons; in such cases, an emergency cash fund makes sense. However, anecdotal and empirical research indicates that people prioritise cash over equities for all kinds of less defensible reasons.

Investing novices are liable to hold hopelessly undiversified portfolios. Holding a handful of stocks increases the risk of heavy losses, potentially turning battle- scarred investors off equities for good. In Ireland, the obvious example is Eircom, whose initial public offering as Telecom Éireann in 1999 will not be remembered fondly by the hundreds of thousands of small-time investors who bought into the hype.

Much greater traumas were to follow during the 2008-2009 banking crash, when shareholders in Ireland’s biggest banks, once thought of as safe blue-chip stocks, were wiped out. Many were older, risk-averse investors depending on the dividend yield such stocks had traditionally delivered to augment their pensions.

Diversified portfolio

Many investors, burned by those experiences, may see the stock market as little more than a bad gamble. In truth, the real lesson is that betting the farm on a handful of stocks, not matter how safe they may appear, is always a bad idea and no substitute for a diversified international portfolio.

Incidentally, Irish investors are far from alone in taking a dangerously undiversified approach – one 2004 study that examined more than 60,000 accounts at a US brokerage found that the average investor held just four stocks, with more than a quarter holding only one stock.

Others fail to save appropriately for retirement simply because they fail to understand the power of compound interest. According to a 2015 study, The Role of Time Preferences and Exponential-Growth Bias in Retirement Savings, almost 70 per cent of people suffer from exponential-growth bias – that is, they don't realise the truth in the old saying about great oaks growing from little acorns.

It is easy to underestimate the snowballing effect: note that a €20,000 investment compounding at 10 per cent annually will grow to €134,550 after 20 years; €348,988 after 30 years; €905,185 after 40 years and to almost €2.35 million after 50 years.

Investment career

Consider too the case of investing legend of Warren Buffett, whose percentage returns were far greater in the first half of his half-century investment career. Nevertheless, roughly 95 per cent of his wealth was earned after his 60th birthday and 99 per cent of it after his 50th birthday.

People who fail to grasp compound interest – that is, most of us – are liable to “underestimate the returns to savings and the costs of holding debt”, the researchers caution. One mental shortcut that can be useful in this regard is the so-called rule of 72; by dividing 72 by the annual rate of return, investors can calculate roughly how long it will take for an investment to double (for example, an investment returning 6 per cent annually will double in 12 years, an investment returning 9 per cent annually will double in eight years, etc).

Similarly useful shortcuts include the rule of 114, which helps calculate how long it will take for an investment to triple, and the rule of 144, which calculates how long it will take for one’s funds to quadruple.

Present bias

Present bias – a tendency to delay decisions that result in long-term benefits but short-term costs – is the other obvious reason why people tend to stick with cash, according to the authors of the above-mentioned paper, who found that more than half of people are prone to this form of procrastination. In fact, 90 per cent of people are prone to either present bias or exponential-growth bias, they said, with both factors “highly significant in predicting retirement savings”. If present bias and exponential-growth bias – let’s call it compounding bias – could be eliminated, retirement savings would increase by between 12 and 70 per cent, they calculated.

Improved financial literacy programmes might boost retirement savings, according to Prof Annamaria Lusardi, founder of the Washington-based Global Financial Literacy Excellence Centre. Simple financial literacy tests conducted by Lusardi reveal that financial literacy is a global problem, with many people incorrectly answering simple questions relating to inflation, compound interest and diversification. Indeed, diversification appears to be a particularly tricky issue, judging by one question in her literacy test which asks people to say whether buying a single company stock usually provides a safer return than a stock fund (the opposite is true); almost half of US respondents did not know the answer, and similar results were found in virtually every other country where the survey was carried out.

Research conducted in the Netherlands suggests a substantial increase in financial literacy is associated with a 17 to 30 percentage point probability of stock market participation and retirement planning, according to Lusardi.

Retirement income projections

One way of catalysing sensible asset allocations might be to provide people with retirement income projections along with enrolment information. According to one paper, What Will My Account Really Be Worth? An Experiment on Exponential Growth Bias and Retirement Saving, people who made a change in contributions upped their annual savings by about $1,150.

However, the authors admit this policy is “not likely to lead to a saving revolution” – most people made no changes to their retirement plans. Indeed, some research suggests the benefits associated with improved financial literacy may be overstated.

Another Dutch study, Is Information Overrated? Evidence from the Pension Domain, found that most people, "even when informed about a considerable drop in their expected pension income, will not take action". Rather than providing people with factual information, policymakers should consider "behaviourally inspired choice architecture".

That brings to mind the auto-enrolment proposal advanced by behavioural economist Richard Thaler.

Pension fund

Conscious that many people don’t get around to retirement saving due to inertia, Thaler recommends that a portion of workers’ pay be automatically directed into a pension fund, while allowing employees to opt out if that is their wish. Thaler also recommends a policy of auto-escalation, whereby one’s contributions automatically increase over time. Thaler’s research indicates that most people stick to the default option, so much debate is focused on arriving at an appropriate default asset allocation.

Opinions vary on the subject of asset allocation, but most advisers agree on one thing: excess cash may be comforting but it’s ultimately costly.