In investing, human emotions can be your own worst enemy. If you can’t control them, your returns will disappoint.
The proof: over the past 20 calendar years, the US stock market increased, on average, by 9% / year. However, individual US stock investors earned only 3.8% / year in their mutual funds. Over 40 years of saving, that difference equates to giving up two-thirds of your potential retirement nest egg.
Why the huge gap? Although mutual fund fees explain around 1%, human emotion is the main culprit. The average investor panics when markets decline, and sells near the bottom. He puts his money in cash. Once markets go up, he starts investing again, and as the market strengthens, he chases performance, buying even more, near the top. The cycle repeats. What’s worse, most investors don’t even know they are in the “buy high, sell low” club, because they don’t track their investment returns.
Over the last several decades, academics have performed extensive research in the field of behavioral economics. In another letter I’ll have more to say about factors such as over-confidence, simplification, self-serving bias and groupthink, some of the key factors causing us to make mistakes as investors — and explaining why almost everyone reading this will think they are better than average. (I know I do!)
The good news: you can avoid the average investor’s fate. You have two options. First, understand these weaknesses and fight against them, by making a plan in “calm” times and sticking with it, regardless of market conditions. Hold yourself accountable (in other words, keep score). Option two is to hire an adviser. A third party can more easily ignore emotion, especially in the heat of the moment. If the adviser has seen enough cycles, he or she can help you keep the short-term market gyrations in perspective.
If you can truly control your emotions – or have someone do it for you – you’ll be way ahead of most investors.