By 2017, a moderate portfolio composed of 60% stocks and 40% bonds had generated about 6.4% annualized returns over the last 20 years. However, the average investor saw roughly 2.6% a year for the same period. This rate of return only slightly outpaces the rate of inflation. Why? What causes the typical investor to underperform so significantly? According to Dalbar’s Quantitative Analysis of Investor Behavior, the answer is in our psychology. Human beings are poorly equipped to handle the emotional stresses of investing. Watching life savings lose a third of its value in a single year, as it did in 2008, has a profound effect on the investor’s emotions. Research shows that this effect impairs the investor’s ability to make decisions. The good news is there are a few simple steps you can take to minimize the impact your emotions have on your investments.
First, do not try to time the market. Common sense will tell you that you want to buy low and sell high. However, investors tend to do the opposite. Stock performance tends to be cyclical, which means that periods of strong stock performance tend to be followed by periods of weaker performance, and vice versa. As stocks begin to rise, investors get excited and overconfident, increasing their risk toward the top of a cycle. As markets begin to fall, they begin to experience fear and regret that can often lead to decreased risk at the bottom of a cycle. This leads an investor to effectively buy high and sell low (see figure below). A great way to combat this emotional reaction is to simply stay invested. Talk to your advisor about what portfolio makes the most sense for you and just stick with it. If you try to time the market, studies show you will likely lose the money you are trying to protect.
Second, diversify your portfolio. Investors seem to think they are better at predicting the future than they actually are. Three major thought patterns are responsible for this misconception:
- Hindsight bias – thinking past outcomes were more obvious than they were (i.e., hindsight is 20/20)
- Confirmation bias – looking for information that you agree with and avoiding information that you do not agree with
- Self-attribution bias – all good investments were due to skill, but all bad investments were just bad luck
These tendencies can cause investors to become overconfident in their ability to pick “good” investments. Often this leads to people concentrating in a stock that they “know” will do well. Rarely do these concentrated bets play out, and they are a big reason why the average investor’s portfolio underperforms to their expectations. The best solution is simply to invest in a diversified portfolio. Investing in a diversified portfolio of good investments keeps you from risking everything on one endeavor and allows you to experience a more consistent return.
Investing in today’s information age can be stressful. Headlines can make every political change and market move seem more frightening. Unfortunately, the research shows this is also affecting how investments are made. An optimal way to fix this issue is to find a diversified portfolio that is right for you and stay in it. Volatility is likely to increase in the coming years, but as long as you stay invested, you are likely to do much better than the average investor.