Humans have a tendency to behave irrationally when it comes to money. Here are the five things investors get wrong that can harm their returns.
Believing They Will Beat the Market
Study after study shows that investors, including professionals, continually under perform the S&P.
In their most recent SPIVA (S&P Indices vs. Active) report, released in September, McGraw Hill Financial found that more than 85% of all funds underperformed the S&P 500, the index found to represent the overall market. (1).
What’s scarier is the fact that individual investors do even worse. In a 20 year study conducted by Dalbar, a financial services research firm, the average investor has seen a return of just 2.1% compared with the S&P’s annualized return of 7.8% (2).
What causes this under performance?
According to Dalbar the biggest reason for this under performance by investors is due to irrational behavioral biases. These include panic selling, under-diversifying, and chasing momentum (3).
Chasing Hot Stocks
In a study done by the University of California Berkley, as well as UC Davis, researchers found that investors are much more likely to purchase shares in companies that have recently been in the news (4), bidding the price of these stocks up.
Additionally many investors make the mistake of trying to chase performance by buying investments that have already risen significantly. A 2011 study by Baird, a wealth management firm, suggests that investors generally chase short-term performance by buying funds that have risen in the short run, and selling those that have performed poorly (5).
The same can be said about the market as a whole where investors tend to purchase stocks after they have seen a large rise, and subsequently sell into weakness (6).
In short, investors sell low, and buy high.
You probably know that fees are important, what you may not realize is just how important they are.
Take for example two 30-year-old investors who each contribute $5,500 annually to their IRAs. They both achieve 9% annualized returns, before fees, over the next 35 years. The only difference between them is that one investor pays annual fees of .5%, while the other investor pays 2.5% in total fees. Over the course of their working career, investor A will have accumulated $1,059,859.21 in their account while investor B will have $682,190.80.
This is a hypothetical illustration only and is not indicative of any particular investment or performance. Return and principal value may fluctuate, so when withdrawn, it may be worth more or less than the original cost. Past performance is no guarantee of future results.
In this example, Investor B’s IRA will be worth less than 65% of Investor’s A account as a result of a 2% difference in fees!
While buy-and-hold is usually a good strategy for most people, it is sometimes necessary for individuals to make slight tweaks to their investments.
This is particularly important if you have had one asset class or investment rise or fall significantly more than the rest of your portfolio. In this case it is a good idea to re balance your portfolio in order to realign it with your target allocation. This ensures that you not only maintain diversity, but also that you buy low, and sell high, by buying assets that have fallen significantly and selling assets that have risen.
Turning to the Wrong People for Advice
Financial advice and information has never been more accessible to the average investor than it is today. Between TV and the Internet, investors are bombarded with information on a daily basis. Unfortunately not all of this information is sound.
Investors should consider carefully the source of any advice they receive, watching out for potential conflicts of interest. Before making any investment decisions you should carefully consider all options, and consider speaking with a financial advisor.
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The Psychology of Investing