Real Life Resources

Emotional Investing: A Losing Game

Financial websites and TV provide background noise almost everywhere these days. But the excitement may not be good for the health of your portfolio.

Market Psychology 101

Experts say that fear and greed drive investors. This is how it often plays out:

  1. When the stock market, or a particular stock, is going up, people tend to jump in.
    1. This is an example of “recency bias,” a fancy term for the commonplace belief that prices will continue on the same trajectory (in this case, up).
    2. Many ignore the familiar refrain: “Past performance is not indicative of future results.” Investors want to get in at any price (greed).
    3. This is what caused the NASDAQ to shoot ever higher during the Internet bubble in the late 1990s.
  2. Let’s say a negative report comes out on a stock or perhaps the economy. Then many investors want to get out fast so they won’t lose money (fear).
    1. All the selling creates downward pressure and causes the stock (or the market) to decline further.
    2. Now the “recency bias” is downward: people think the market will keep going lower.
    3. When the Internet bubble popped, sellers flooded the market and caused the NASDAQ to crash.

Too Much Trading

People buy and sell stocks and bonds to make money. But research shows that attempting to time the market seldom works in the long run.

  1. A Gerstein Fisher Research study covering the 15 years between 1996 and 2010 examined actual investor returns vs. the average performance of each asset class using data from 25,000 funds in the Morningstar database.
  2. The results of this study were surprising:
    1. The S&P Index generated a 6.66% average return.
    2. But the average investor’s funds tracking this index saw an increase of only 1.03% (adjusted for inflation).
  3. The reasons for the shortfall include the usual suspects:
    1. Inflation (2.41%)
    2. Tax costs (1.30%)
    3. Fund expenses (.92%)
    4. d. So what happened to the other 1%?

Mind the Gap

  1. It turns out that the 1% gap between the index performance and that of individual investors is attributable to poor market timing and trading activity.
    1. It’s not chump change either: 1% of return each year compounds and is a huge drag over long investment horizons.
    2. Note: Unlike taxes and inflation, the amount of trading is something over which investors may exercise a considerable degree of control.
  2. Records show that peak inflows to bond funds occurred just after the 2007-2009 stock market swoon — exactly the time investors should have been putting money into stocks.

It’s tempting to try to outperform the market. But it’s almost impossible to do so on a consistent basis. Before taking chances, ask yourself if it’s really the best way to fund the lifestyle you want for yourself and your family.

 

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