Individual investors are more empowered than ever before. Armed with online tools and mobile apps designed to educate and make even the most complicated investing decisions quick and easy, there’s never been a better time for those who want to optimize their portfolios. Empowerment, however, can be a double-edged sword: Study after study from sources like Morningstar and Dalbar show that when individual investors are left completely on their own, they dramatically and consistently underperform the broader market.
How much does a typical self-directed investor lag the overall stock market? According to Bloomberg, it varies, but it’s clear that the performance gap is real. Lou Harvey at Dalbar points out that when people think they can know the unknowable, they lose one-third to almost half the potential gains the market produced. His behavioral studies show that over a 20-year period ending last year, the overall return for the S&P 500 index was 8.19% a year; individual investors managed to earn just 4.2% a year.
Why Investors Leave Near Half Their Potential Gains on the Table
Two fundamental factors get in the way most often: emotions and transaction costs. In fact, one feeds right into the other.
The problem is that individual investors tend to react to every headline they read or hear instead of researching good investments, then sticking with them. Whatever has just happened most recently in the market tends to drive their next investment decision. Researchers at the University of California highlighted how this works through behaviors now referred to as the “disposition effect.” It’s an academic way of describing how when people react, rather than invest, they wind up losing money by dumping their winning investments and hanging onto their losers, and it’s not unlike gambling behavior.
Just how trigger-happy are self-directed investors? Credit Suisse estimated in April 2015 that the average U.S. stock was held for just 17 weeks. The annual turnover rate was 307%. It’s not just amateurs who try to outguess the market. Professional portfolio managers were also part of this same study, and it shows just how short-term the markets are looking. Pair this data with the studies showing that investors who trade the most earn the least (such as this one in The Journal of Finance), and you can see the problem clearly.
Then there are the extra fees all this buying and selling generates. Investors sometimes don’t even realize they’re paying these fees, and as they try harder and harder to improve returns, they wind up giving some of their returns right back.
This kind of behavioral research can be useful right about now. Believe it or not, the current bull market in stocks turned seven years old this year, and many experts are sounding the alarm bell as stock prices keep reaching new highs. Nervous investors may believe the good times are about to change and many will sell now. But remember, this isn’t the longest-running bull market in history. The longest bull market ran almost ten years from October 1990 to March 2000. No one knows how much stock prices will go up or down over the next two years, and no one can possibly know when things will change.
Two Simple Rules to Help You Get Out of Your Own Way
1. Commit to a long-term, fully diversified game plan.
You can accomplish this easily in one of two ways. The first is to go online and set up an account with a robo-advisor that uses an algorithm and software to help generate a portfolio of investments for you. It can even help you stay on track by automatically re-balancing your holdings. The other option is to find a fiduciary financial advisor who charges either per consultation or by the hour. Investors with complicated finances are better suited for human help than for a robo-advisor.
2. Make fewer transactions.
Your plan should be based on long-term investments because every transaction will cost you. Before you do make a trade, factor in all the transaction costs associated with that decision; ultimately, those fees come out of any profit you might make. If you really want to trade often and gamble, do it with a very small amount of your savings. After all, that’s why Jim Cramer’s show is called “Mad Money.”
These two steps go hand in hand because if you have a smart, fully-diversified asset allocation plan, you shouldn’t have to be making a lot of transactions and paying out lots of money in fees. Diversification wins all battles; it’s a formula that will stand the test of time – think 10 to 20 years or more, rather than weeks or months.
Warren Buffett explained in his 2013 annual letter to Berkshire Hathaway shareholders that in his will, he instructed his trustee to put a percentage of the cash he leaves to his wife in bonds and the rest in “a very low-cost S&P 500 fund.” In other words, he wants his wife to be set with a plan to last her the rest of her life after he’s gone – wise advice from one of the most successful long-term investors of all time.
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