Image Source: Getty Images/Anthony Harvie.
Is it the legendary “Wolf of Wall Street” Jordan Belfort? Is it Bernie Madoff? Is it the estranged uncle offering you double or even quadruple your initial investment? Perhaps.
Try this: go to your washroom and take a clear look in the mirror. People’s worst enemy in investing most often tends to be themselves.
So let’s assume that investors have done everything right on the investment vehicle level and have chosen low cost index funds over an actively managed fund. Even though these investors have chosen a superior class of funds, their performance is still largely affected by simple psychology. A study released by Dalbar, a Boston-based research company, quantified how investor psychology affected investors’ portfolio performance negatively. The problems of investor psychology affecting portfolio performance go beyond buying and selling at the wrong times. It is about simple psychological traps that cause investors to act irrationality which in turn leads to underperformance. You really are your worst enemy when it comes to investing. Research proves it beyond a doubt.
Just how specific can investor behaviors affect performance? Dalbar releases research reports annually which quantify the loss magnitude such detrimental investor psychology causes in the average investor's portfolio. Some of these key findings were as follows:
In 2014, the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%.
In 2014, the average fixed income mutual fund investor underperformed the Barclay’s Aggregate Bond Index by a margin of 4.81%
In 2014, the 20-year annualized S&P return outperformed the 20-year annualized return for the average equity mutual fund investor by a gap of 4.66%
In 8 out of 12 months, investors guessed right about the market direction of the following month. Despite this, 67% of the time in 2014, the average mutual fund investor was not able to beat the market based on actual volume of buying and selling at the right times.[2]
The sad irony about these findings is that these 2014 was not an exception, unfortunately! Dalbar consistently finds the exact dismal underperformance results in each year since starting their annual study in 1994! Why does this happen?
Have you ever fallen victim to an exciting news story about a new technology or product only to find it to flop later on? Have you ever joined a new fad or craze that you look back on with regret? Even those who decided to divest from their funds in the 2008 global recession found out that the value would more than likely recover in a few years’ time. No amount of training or knowledge can prevent these psychological traps that lurk for all of us. This happens with both the overconfident during boom times and the people who abandon sound investment planning during bust times.
We have seen it with the Dutch Tulip Trade in the 17th century. We have seen it with the biotech bubble in the 1980s. We have seen it with the dot-com bubble at the beginning of the 21st century. Even those who seek to capitalize others’ irrationality can and consistently do fall victim to these crashes as well. Burton G. Malkiel mentioned the failure of the practitioners' “greater fool theory” in his book A Random Walk Down Wall Street.
So how does one prevent such losses?
We may never be able to profitably predict where stocks move with 100% certainty. Luckily, we can look at the benefits of investing in the market as a whole. History has shown that markets tend to recover their value in time and may even gain value as time progresses. [3] The following graph will illustrate that point properly.
Image Source: Global Financial Data.
As one can see by the historical prices of the Dow Jones Industrial Average, the stock market always tends to recover and even thrive after times of recession.
Greed and fear have left many men in financial ruins. Deviations from one’s investment strategy can best be fought with a buy and hold strategy that focuses on one’s goals. As you may know, one of the cheapest and most effective methods to gain appropriate market exposure is to invest in low-cost index funds. We recommend the following steps to keep your portfolio performance up to the time tested strategy of evidence-based investing.
Make an investment plan and stick to it. This may be the hardest thing that most investors will have to do.
Keep investment costs low and stay well diversified by using ETFs/index funds while staying within your own risk profile. Some people can afford to take on more risk, some people cannot. Keep this in mind when making your investment decisions.
Rebalance once a year. This will prevent you from buying high and selling low during times of boom and bust.
Disregard the financial media. Steve Forbes once said, “You make more money selling advice than following it.” The financial print media knows this and does their best to keep you ordering their magazines, while the financial television media happily sells advertising minutes to entice its viewership to tune in on a daily basis.
Remember; do not give into greed by those promising above-market returns with little or no risk. Las Vegas was not built on winners. Also, do not give into fear during times of market panic. Several retirement plans were decimated by those seeking to “cut the bleeding” during the 2008/2009 recession. Just as only one of many examples, Fidelity had done a study in 2014 to figure out which accounts had performed the best over a 20 year investing period. The result? People who had forgotten that they even had an account with Fidelity!
By staying level-headed and calm, investors can stay on the straight path to financial security by avoiding their worst enemy: themselves.