One of the smartest things you can do as an investor is to stop making moves based on your gut instincts. You will probably become a much better investor, because studies show your portfolio is likely to perform better if you avoid excessive trading.
It’s tough to ignore these impulses when stocks are turbulent, up one day and down the next. But if you’re trying to time the market based on hunches — your own or those you hear from friends, family or media “experts” — you could be setting yourself to make the wrong investment decisions, causing your investments to underperform.
Emotional decisions are usually bad decisions; after all, no one ever intends to sell low or buy high. But that’s what can happen to investors who are working without an investment plan or who stray from their plan because they get nervous or greedy.
According to Dalbar, the consulting firm known for its annual “Quantitative Analysis of Investor Behavior” studies: “No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market.”
Every year Dalbar compares the returns of investors to benchmark indices over various periods of time, and the differences are significant. In the 30-year period ending December 2016, for example, the S&P 500 averaged 10.16%, while the average active equity fund investor earned 3.98% annually.
Now, I know what you’re thinking — and you’re right: Part of that discrepancy is due to fees. But the big difference, Dalbar points out every year, is the timing decisions investors make. Here are some of the mistakes I see investors make over and over:
1. They fall prey to “recency bias”
When it comes to investing, their gut tells them to buy when the market is going up — and to buy the funds that have been going up recently. They also tend to avoid the stocks and funds that have been doing poorly, assuming things will continue to occur just as they have been. But of course, that’s not how it works.
With a 24/7 news cycle and today’s global market, seemingly any little thing can change an investment’s value overnight. If you see a blogpost that says, “5 Funds to Buy This Year,” it’s probably based on the five funds that did the best last year. NO ONE knows how they’ll do in the future.
2. They feel the need to make adjustments
Generally, there is no need to make major adjustments over the short term. Investors should have a long-term time horizon. Otherwise, every downturn can seem potentially devastating, and the temptation to sell can be overwhelming.
During the financial crisis of 2008, there actually was a spike in Google searches for chest pains, headaches and ulcers. People became physically ill as they watched their accounts lose value. They needed to feel better, and the way to feel better was to get out of the market.
The problem with that is that most investors lack a definitive re-entry strategy. What is the plan to resume your investment strategy? When your gut tells you it’s time? When your nerves calm down after a year on the sidelines? When you see the market has been up 20% for six months?
If you don’t have an exit and re-entry strategy, your best bet is to simply sit tight and wait for your investments to rebound.
3. They don’t understand volatility or their personal risk tolerance
Managing a client’s investment behavior is a financial professional’s most important role. Your adviser should help you create a portfolio that’s adequately diversified, mitigates risk and keeps volatility low, so you can enjoy the returns from your investments instead of bailing out too soon.
How soon is too soon? The reason the S&P 500 consistently outperforms investors in the Dalbar study is because most investors are unable to endure the market’s volatility.
Warren Buffett’s advice is to “Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”
To get the rewards of the stock market, you need to be able to ride out the volatility, but everyone has their limits. Know yours. You should understand going into any investment what the risks and possible range of returns are so that in a worst-case scenario you aren’t surprised. I believe that’s your best shot at remaining disciplined.
4. They don’t know where else to go with their money
People often think they’re “diversified” if they have a few different mutual funds. But a truly diverse portfolio combines traditional investments (with some high- and some low-volatility choices), alternative investments (real estate, commodities, private equity, etc.) and insurance products (indexed annuities and modified endowment contracts). Some investments are correlated to the stock market and some are not.
Most 401(k) plans have limited investment options, so investors may have to utilize non-retirement assets to balance out their portfolios.
5. They aren’t paying attention to their personal timeline
The closer you get to retirement, the more you’ll need to consider wealth preservation over accumulation. It’s critical that you protect the money you’ll need for income when your paycheck goes away. It’s OK to remain aggressive with some of your funds if you have other assets that will keep that income flowing when (not if) the market takes a dip. But if your savings are limited, you should be dialing down the volatility in your portfolio as you get older.
The best way to avoid these mistakes is to make and stick to a financial plan. Knowing where you’re going and how you’re going to get there can make the journey far less challenging.
Start with products and strategies that suit your needs. Talk to your adviser and assess the pros and cons. And every time you’re tempted to make a change, resist those impulses and stick to your plan.
— The Option Specialist