Are Investors Their Own Worst Enemy?
When it comes to investing, people can be their own worst enemy. Nearly all of the mistakes made by investors can be attributed to their behaviour, which is typically dictated by their emotions. Fear and greed have ways of influencing the investing decisions of even the most rational people; which is why most investors typically underperform the markets. According to a 2015 study by DALBAR, the returns most investors experience lag the actual returns of the mutual funds they buy. In 2014, the average equity mutual fund investor underperformed the S&P 500 by a wide margin of 8.19%. Over the 20 year period ending in 2014, the S&P 500 index returned 9.85%, but the average equity fund investor only earned 4.66%.1
Why? DALBAR concludes that investors behave their worst when the market is doing poorly, selling as soon as they have a big paper loss and then sitting on the sidelines until the markets have recovered their value. Therefore, they tend to participate in the market primarily when it is in retreat, and miss the market when it is on the rise.
Some of the many behavioural mistakes investors make are:
Trying to time the market
While it’s not impossible, few investors have been able to move in and out of the market at the right time consistently enough that they gain any significant advantage over the buy-and-hold crowd. Morningstar estimates that the returns on portfolios that tried to time the market over the last decade underperformed the average return on equity funds by 1.5% during that period, and that includes several years of negative returns; to have better results, investors would need to have called the market shift seven out of ten times, a feat that true timing pros have a hard time matching.
Trying to pick the winners
Over the period from 2006 to 2010, only 48% of managers of large-cap funds were able to beat the S&P 500. The vast majority of them barely edged out the index. It gets worse for portfolio managers who focus on the international markets - only 18% managed to outperform the international index. What this means, is that in that period of time, if you had simply invested in an S&P 500 index fund, which required no active portfolio management (meaning you also wouldn’t have paid the 2% investment management fee), you would have earned a better return than more than half of the portfolio managers.
Reacting to short-term events
The behavioural instinct of humans to want to do something in response to extreme market events is a survival mechanism that tends to work against us in the investment sphere. Studies have shown that the more often one changes one’s portfolio, or for that matter, even looks at it, the lower the return will be. When investors shift their focus away from their long-term objectives to short-term performance, the results are almost always negative. This can best be illustrated when investors bail out of a declining equity market with the intention of getting back in when it turns around – a feat very few investors can actually achieve, leading Warren Buffet to quip, “The stock market is a highly efficient mechanism for the transfer of wealth from the impatient to the patient.”
Market crashes, financial meltdowns, Middle East wars, and tsunamis are all consequential to our lives in the moment; however, their impact on the markets over a 20 or 30 year period is so minimal, that they often cause nothing more than a tiny blip on your long-term investment performance.
Whether investing for retirement or any other objective, the biggest mistake many people make is not having a sound investment strategy in place to guide their decisions. The challenge in investing is not that it takes special skills or knowledge; it’s that it is often driven by emotions which can be devastating for investors who lack a clear investment strategy along with the patience and discipline to follow their plan. Without an investment strategy based in sound principles and practices, investors will more often than not, succumb to their emotions of greed and fear which causes them to act in ways that are in opposition to their long-term needs.
Investors must start with a goal, a targeted objective, with a specific time horizon so they can determine how much they need to invest, what rate of return is needed on their investment, and how much risk they will need to endure in order to achieve the desired rate of return. Then, with the help of a trusted, independent investment advisor, investors need to construct a properly diversified investment portfolio allocated across several asset classes that reflects their specific objective for growth for the next 15 to 20 years. The only time they should buy or sell any securities after that is when their investment objectives change (which should be rare if they’ve planned properly) or to rebalance their portfolio each year to bring it back in line with their targeted asset allocation.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2014-2016 Advisor Websites.