Investors’ Worst Enemy? Themselves

in Investing by

[dropcap]T[/dropcap]his is likely not going to be news to anybody, but investing isn’t easy. And many feel the system is rigged against the main street investor. Indeed, the industry has no shortage of trickery and our regulators have failed miserably to protect us. Combine that double whammy with a media that sensationalizes everything and pretends to know the future, and you have a mess of a trifecta that certainly isn’t making investing any easier. Yet, I feel it isn’t even a close call that investors are their own worst enemies. Here’s why and how you can watch out for your own bad behavior.

Human behavior

There is conclusive evidence that investors underperform financial markets due to costs. But the evidence is just as conclusive that investors also underperform further by chasing performance. Investors see the attractive stock returns from 2003-2007, and change their allocations to be heavily in stocks. Cash flowed heavily into stock mutual funds during this period. Then, when markets plunged in 2008 and early 2009, investors panicked as evidenced by the flow out of stock funds and into cash. Of course, in early 2009, the mantra “cash is king” was the popular saying, yet nearly every asset class but cash performed well in the next couple of years.

Most people know the average mutual fund underperforms their benchmark because of fees. On top of this, my own research indicates that the average mutual fund investor underperforms the average mutual fund by about 1.5 percent annually. Other studies show this underperformance to be significantly greater.

This under-performance comes not only from timing stocks wrong, but also from entering whatever is hot and exiting whatever is not. We go into emerging markets confident of our logic that that the economies of Brazil, China, and India will grow faster than developed markets, seeming to forget that every human being on the planet already knows this and it’s priced into their markets. We will panic and sell yet again when they have a bad run. And what could glitter more than gold?

The emerging field of behavioral economics shows that humans are anything but logical wealth-maximizing creatures. We are driven by fear, greed and have a host of biases that act against a wealth maximizing mode. Like performance-seeking missiles, we are programed to move our hard earned money into whatever had performed the best over the recent past, naively expecting this short trend to continue indefinitely.

Clearly the media aids investors in performance chasing, yet nobody is holding a gun to their heads and telling them to behave badly. Investors do it all on their own and repeat this same mistake over and over again. People love to think of themselves as contrarians, since it’s more appealing to be a maverick than a lemming. But the terrible truth is that human beings are herd animals.

Control your behavior

Though I will never claim to be able to predict the stock market, I can predict something almost as important – investors’ behavior. If stocks do well, investors will buy after the gain and, if stocks dive, investors will take their money and run.

Focus and discipline is what will win the day. It’s simple to pick an asset allocation and stick to it. It just isn’t very easy. In fact, it gets harder the more money means to us.

Don’t follow the herd. Investing herds get slaughtered over and over again. Remember that the one key sign that you are investing well is that it hurts. No one said it better than Warren Buffett. Be greedy when others are fearful and fearful when others are greedy.

 

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