Your Guide to Finding the Best Financial Professionals for You
If simply reading these questions makes you feel uneasy, you’re not alone. There are few...
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However, a report from Morningstar makes it clear that our constant need to tinker with our portfolios is costing us big time money.
Morningstar looked at the average return of investment funds over the past 10 years and compared that to the actual return that investors in those funds received. They found that the average investor trailed the return of the funds they were invested in by nearly 1% per year during that time.
95 basis points is a meaningful difference. Let’s say you invested $100,000 when you were 25 and never invested another dime, and pulled the money out at age 65.
The DIY investor in this example would cost themselves nearly half a million worth of wealth over their lifetime. The larger the lifetime investment, the more wealth they would be giving up.
All humans suffer from a number of cognitive biases that lead to irrational investment decisions.
There are three psychological traits in particular that are hurting DIY investors.
Fear and greed are two halves of the same coin. In their report, Morningstar found that in periods after funds performed exceptionally well investors poured in a lot of additional money into that fund. Following periods of underperformance, investors began selling off their investment in that fund.
Translation; Investors were buying high and selling low. You don’t need to be Warren Buffet to realize that isn’t a recipe for investing success.
DIY investors also suffer from another bias; overconfidence. If you are a DIY investor you believe that you will have a better outcome managing your own investments than paying a professional to do it for you.
This overconfidence can lead to market timing decisions that seem like good ideas at the time, but most often lead to underperformance. These are the people who say things like “I don’t want to invest right now while we are at the top of the market”.
By holding their money out of the market, they are betting that the market is about to crash. In reality, market timing is nearly impossible to successfully pull off and your most likely outcome is missing out on future gains.
As I’ve written in the past, there is enough academic research to conclude the stock market is reasonably efficient. This means that trying to time the market or pick stocks or engage in any activity to try and “beat the market” is likely to fail and cost you money.
Standards & Poor’s collects data on how actively managed funds perform against their benchmark index across the globe.
Over the past 5 years here is what they found.
There is no country in the world where a significant number of actively managed funds beat their respective indexes.
The managers of these investment funds are very intelligent people with more resources and more investing experience than you have. If they can’t beat the market, what makes you think you can?
Don’ bother trying. Invest in a passively managed fund that tracks the entire stock market. Then treat it like a passive fund by simply buying and holding.
Adopting a passive buy and hold strategy helps us deal with overconfidence bias. The only thing that can derail this strategy is fear (selling low) and greed (buying high).
To overcome fear and greed, simply do nothing.
Fidelity did a study that found the best-performing investors all had one thing in common: they forgot they had an account with Fidelity. Which means they never checked their account balances.
One of the most effective ways to manage the fear of large market declines is not to overexpose yourself to the stock market. That means having a balanced portfolio of stocks and bonds.
A portfolio invested 100% in stocks is not appropriate for two groups of people.
It just so happens that nearly everyone will fall into one of these categories. Most DIY investors probably think of themselves as the ultimate rational investor who won’t make emotional decisions with their money. This is another form of overconfidence.
The Morningstar data of investors underperforming their funds suggests that most people do in fact make emotional-based decisions. That includes selling when the market is down and locking in losses.
Watching your portfolio drop by 40%-50% in a single year is a scary and real possibility if you are invested 100% in stocks. This causes fear which can lead to an irrational decision to sell and lock in losses.
If you’re invested in a portfolio that has a healthy allocation to bonds it’s much less likely to see such steep losses and things seem a little less scary.
Investing in bonds may lower your “expected return” as stocks tend to outperform bonds in the long run. However, if you’re an emotional investor (which the data suggests you are), you should be happy to trade off some expected return to save yourself from yourself when sh*t hits the fan.
Are you a DIY investor? How do you allocate your investments and how often do you buy and sell different investment products? Let me know in the comments below.
Disclaimer: The information in this article is not intended to encourage any lifestyle changes without careful consideration and consultation with a qualified professional. This article is for reference purposes only, is generic in nature, is not intended as individual advice and is not financial or legal advice.