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Good investing habits that make your primitive ape brain hurt
Posted By Claes Bell On 12/09/2013 @ 8:30 am In Science Says | 8 Comments
Between 1993 and 2012, individual investors earned an average annual return of 2.3 percent, according to a study by DALBAR, a financial services market research firm. That’s not only terrible, it’s a lot less than the 8.2 percent they would have earned just parking their money in stocks of the 500 largest American companies and reinvesting the dividends.
So why does this happen? Is it because a big percentage of Americans are dumb mouth breathers who should be relieved of their brokerage accounts before they have the chance to invest another dollar? Not at all. DALBAR researchers chalk up the difference to “psychological factors,” such as herd instinct and loss aversion, which “account for 45 percent to 55 percent of the chronic investment return shortfall.”
So for a lot of investors, the issue isn’t intellect, it’s psychology. Good investing habits require doing things that run so completely against the grain of human psychology it can make your brain hurt. Here are a few:
1. Rebalancing your portfolio regularly. Over time, some investments do better than others and end up occupying more space in your portfolio than they’re supposed to. With rebalancing, what you’re doing essentially is taking money out of investments that have been doing great and putting it in investments that haven’t been, in order to get things back in order.
The problem is, taking money from your “winners” and giving it to your “losers” can feel a little bit like taking your star quarterback out of a career game and putting in the gangly third-string guy because strategy or something.
But rebalancing about once a year really helps you boost returns over the long term, says Judy Ward, senior financial planner with T. Rowe Price.
“It may feel counterintuitive, because you may be selling off the investments that are doing better, but really you’re taking some of those gains,” Ward says. “It’s a discipline where you’re selling high and buying low.”
In the end, rebalancing actually helps limit your risk by ensuring that if those high-performing assets fall back down to Earth, your portfolio won’t take as big of a hit, Ward says.
2. Staying invested during a crisis. Keeping your money invested in stocks during a big downturn can feel a little bit like hearing the fire alarm go off in a crowded theater and finishing your popcorn while everyone else rushes for the exits.
Sure, it would be great if you could take your money out of stocks right before a crisis, but even the best investors have a hard time distinguishing between a small dip and a big downturn until it’s fully underway. If you sell then, when things are at their most uncomfortable and the market is at its peak uncertainty, you’re actually locking in your losses and ensuring you won’t participate in the rebound.
“When the market’s doing its thing, a lot of people feel like they should be doing something, when many times probably the best thing you can do is nothing, and it’s just very difficult emotionally and behaviorally,” Ward says.
Rather than give in to the temptation to dump everything, it’s often better to just keep chugging along, buying up stocks and bonds while they’re cheap and waiting for the market to recover, she says.
3. Keeping it simple. The world loves an investor who can outperform the market (witness the circus that surrounds Warren Buffett at all times), but the truth is, even the best investment advisers have a hard time doing that consistently over time, and most don’t even come close.
According to the DABAR study, equity funds managed by professionals averaged 4.25 percent a year in returns over the last 20 years, trailing the market by a substantial margin.
In my experience, people tend to believe the more complex and flashy a thing is, the better it works. It’s not just a toothbrush, it’s an electronic toothbrush that cleans with sonic waves! It’s not just a phone, it’s a smartphone with 64GB of memory and a ultra-HD 3D screen! It’s not just a portfolio, it’s a portfolio put together by the fanciest guy in the fanciest office building in New York chock full of venture capital and Bitcoin!
For most people though, when it comes to investing, the better way to go is so simple it seems dumb: buying a few index funds that mimic the performance of the market and carry very low fees. Even without all those bells and whistles, they will likely return more over time than jumping on the latest investing fad, trying to pick the next Apple or even relying on stock picks by a hotshot investment adviser.
That’s not to say that financial advisers don’t have a role to play — they can help you figure out what general categories of investments you should be invested in and how that should change over time. But if an adviser wants to put you in a specialized mutual fund or individual stocks, just remember that stock pickin’ ain’t easy, no matter what school you went to or how much your suit cost.
What do you think? Why are average Americans so bad at investing? What do you think would help them do better?
(Photo: J E Theriot)
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