Investors: Are They Their Own Worst Enemy?

Intro

We want to believe that we are sensible and logical beings. We like to believe that before we act, we assess the benefits and drawbacks of each decision and choose the most effective course of action. However, human brains have not progressed far beyond those of our furry animal relatives when it comes to money.

Money is a contentious issue. According to studies, it is the primary source of stress in our lives, both good and bad. Money is a major source of contention in relationships and the leading cause of divorce during the early years of marriage. Whether it’s a gradual accumulation of assets over time or a huge real or imagined abrupt financial gain or loss, money arrives wrapped in an emotional bundle; and when we’re emotionally aroused, our rational faculties are strained. When our emotions are strong, neuroscience has demonstrated that our logical, reasonable brain shuts down. When it is restored, we often rationalize our actions. Simply put, we cannot trust our intuition when it comes to investing judgments made during times of anxiety or excitement. When we allow our animal brains to make investment decisions, we endanger our financial well-being. – Bradley Klontz, Ph.D.

Individuals can be their own worst enemy when it comes to investing. Almost all investor errors can be ascribed to their behavior, which is frequently determined by their emotions.+ According to a 2015 survey by DALBAR, most investors experience returns that are lower than the real returns of the mutual funds they purchase. In 2014, the typical investor in equities mutual funds underperformed the S&P 500 by an astounding 8.19 percent. The S&P 500 index returned 9.85 percent over a 20-year period ending in 2014, but the average stock fund investor earned only 4.66 percent. 1

Why? DALBAR says that investors are at their worst when the market performs poorly, selling after suffering a significant paper loss and then remaining on the sidelines until the markets regain their worth. As a result, they tend to participate in the market largely when it is declining and avoid it when it is rising.

Behavioral errors investors make

Making an attempt to time the market. While it is not impossible, few investors have consistently been able to enter and exit the market at the correct time to gain a meaningful advantage over the buy-and-hold crowd. Morningstar estimates that during the last decade, portfolios that attempted to time the market underperformed the average return on equity funds by 1.5 percent, including many years of negative returns. To perform better, investors would need to correctly predict market shifts seven out of 10 times, a feat that actual market timing experts struggle to equal.

Attempting to select the winners. Between 2006 and 2010, only 48% of managers of large-cap funds were able to outperform the S&P 500. The vast majority of them came within a hair’s breadth of the index. The situation is even worse for portfolio managers focused on international markets: only 18 percent outperformed the international index. This indicates that if you had merely invested in an S&P 500 index fund during that time period, which did not require active portfolio management (and thus did not require you to pay the 2% investment management charge), you would have received a higher return than more than half of portfolio managers.

Reactions to brief incidents. Humans’ behavioral propensity to react to significant market occurrences is a survival strategy that tends to work against us in the investment world. According to studies, the more frequently one alters or even looks at one’s portfolio, the lower the return. When investors’ focus is shifted away from long-term goals and toward short-term performance, the outcome is virtually always bad. This is best illustrated when investors exit a declining equity market in large numbers with the intention of re-entering when the market recovers – a feat that very few investors actually accomplish, prompting 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 all have immediate consequences for our lives; nevertheless, their impact on the markets over a 20- or 30-year horizon is so negligible that they have no effect on your long-term investment success.

Whether saving for retirement or another goal, the most common mistake many people make is failing to have a plan or a strong investment strategy to guide their selections. The difficulty with investing is not that it requires particular abilities or expertise; rather, it is that it is frequently driven by emotions, which may be disastrous for investors who lack a well-defined investment strategy as well as the patience and discipline to adhere to it. Without a strong investment strategy founded on sound ideas and practices, investors will frequently succumb to the emotions of greed and fear, causing them to act in ways that are incompatible with their long-term objectives.

It must begin with a purpose and a rational and logical plan with a particular objective and time horizon so that you can decide how much money you need to invest, what rate of return you require, and how much risk you will need to take to attain that rate of return. Success should be quantified by posing a few questions to oneself. “Am I on pace to reach my objectives?” and “Does my current strategy provide me the peace of mind and confidence to sleep at night and/or focus on other priorities?” Investments are a means to an end. If the destination is unknown, it is difficult to know, control, and succeed. With the assistance of a reputable, independent investment advisor, you may develop a properly diversified investment portfolio that is evenly distributed across multiple asset classes and matches your individual growth objective over the next 15 to 20 years. After that, you should only buy or sell shares if your investment aim changes (which should be uncommon if you’ve prepared well) or rebalance your portfolio annually to maintain your targeted asset allocation.