The #1 Mistake Made by the Average Investor (And How to Avoid It)
According to the Social Security Administration, the average retiree receives only 36% of their income in retirement from social security retirement benefits. The balance of their income needs are met by defined benefit plans (pensions), personal savings and investments, or they are forced to continue to work. This has made investment results increasingly necessary for individuals to retire successfully.
JP Morgan recently reported 20-year annualized investment returns categorized by asset class. Notably, a portfolio that was invested 60% in the S&P 500 Index and 40% in a high-quality bond index over the past 20 years had an annualized return of 7.2%. Painfully, the average investor only had a 2.1% annualized return over the same period. By engaging in the decision to buy or sell their stocks, the average investor earned almost 71% less than the unmanaged portfolio, each year. Remember, this is over a 20-year period, so these results are compounding year after year. In addition to the lower returns, the 2.1% annualized return was less than the inflation rate of 2.2% during the same period. By virtue of the data, the average investor is clearly making choices that are undermining their ability to meet their long-term financial objectives.
At its most basic level, there are always two parties involved in any single market transaction: the seller of a company’s shares and the buyer of the same shares. The market provides each participant the ability to make decisions in his or her own best interest. (This should be the logical assumption in any transaction; see Adam Smith, Invisible Hand.) Moving along with this line of thought, if the company’s stock price went higher than the purchase price, the buyer would feel like the winner while the seller would feel the opposite. Conversely, if the share price went lower, the buyer would feel like the loser and the original seller, the winner.
Consider the following behavior from our average investor. Our buyer in the initial transaction, in his desire to always make money, has now watched his investment lose value. The circumstances are now inconsistent with his objective, and he now has the urge to protect himself from losing more money. (In fact, studies show the urge not to lose money is stronger than the urge to make money.) Because of this, his resolve to hold on to a stock falling in price quickly wanes, leading him to make the emotion-based decision to sell. What the average investor does not understand is the buyer on the other side of that transaction, who is also looking out for his own best interest, believes he can make money by owning this company. The buyer is certainly not practicing benevolent thinking on the other side of the trade (“Hmm…I think I will give that poor guy a break, he’s suffered enough, let’s take that dog of a stock off his hands.”) No, no, and heck no! That buyer is doing what they believe is in their own personal best interest. He thinks he will make money, so he quickly scoops up our average investor’s shares, most likely at a bargain price. Just like anyone making an emotional decision, our investor has made a poor one, contributing to the 2.1% average investor’s results. This is not the behavior or result we want to emulate, especially when compared with 7.2% annualized returns in an indexed 60/40 allocation.
Unfortunately, this situation takes place regularly, five days a week, between the hours of 9:30 AM and 4:00 PM, Eastern Standard Time on the New York Stock Exchange. By the way, the average US investor does not monopolize this behavior, as it is occurring in stock markets all around the world. Remember, stock markets are not a charity; everyone is doing what they believe is in their best interest when they engage in buying or selling a securitized company. There are winners and losers — not everyone receives a trophy for participation.
So how do you avoid becoming part of the average investor statistic? You have to think like a professional or work with someone who does. Warren Buffett says if you do not feel comfortable owning a stock for 10 years, you should not own it for 10 minutes. He is also famous for saying that his favorite holding period for stocks is “forever.” Like many of his quips, it’s good for a laugh, but also contains a kernel of investing truth: The real gains from stock investing are not made from trading, but from owning. Buffett, like any other good professional investor, owns stocks for a long time, often for decades. Over the years, those investments increase their earnings and pay steady dividends; and when re-invested, they are compounding and increasing your level of ownership while growing your annualized return.
Recent studies have shown that one of the best things you can do to protect yourself from your own natural tendency to make emotional or ill-informed decisions is to hire a financial advisor. If you are reading this article, you are either already a client or, at the very least, open to learning. You are definitely on the right path. Good financial advisors follow a process with every individual they work with; and they create a portfolio that will meet their client’s short and long-term financial planning objectives.
Here at HFG Trust we utilize an “evidence based” approach to portfolio management. In order to implement our strategies, we routinely monitor and adjust the weighting of each asset class within our client’s portfolio based on fundamental value metrics. Our Investment Committee devotes a significant amount of time and resources to understanding the investment climate and determining the balance between risk and reward. This simply means it is important to understand and quantify the value of each asset class before we decide to own it or remove it from our portfolios.
In summary, don’t be average. Make sure you are taking steps to have better results than the average investor. The success of your long-term financial planning objectives depends on it!
Bob Lagonegro, CFP®