The road to hell is paved... written by Glenn Szlagowski, Financial Adviser May 4 2011

“Investors diligently seek investments that they hope will produce the best returns but lose much of that benefit when they yield to psychological factors” --- DALBAR 2011 Quantitative Analysis of Investor Behavior

In a previous article, I mentioned that we will look at a type of investment that may help to short circuit our natural tendencies to inappropriate investment behaviors. Why is this so important? It is because the average investor may be underperforming their investments or the benchmark by up to an incredible 5% per year! [1]

Consider the following scenario. You are in a movie theatre. The theatre is full.  In the middle of the movie someone yells "fire!" There appears to be a wisp of smoke and sure enough the light of the projector beam catches a puff of smoke slowly curling its way to the ceiling. There is an acrid odour. Some people in the front are hurrying for the exits. More people become concerned as the smoke seems to be spreading. The orderly emptying of the bottom rows quickly becomes chaotic as people start clamoring for the exits - any exit. 

The theatre manager blocks one of the main exits to declare that there is really no fire and everyone should calmly return to their seats. The manager gets run over by the crowd but thankfully survives with only a few broken ribs. The manager was right as it turned out. He had caught the miscreant who had set off a stink bomb. 

A financial advisor tells his client(s) that yes, the stock market is indeed plummeting but there is nothing to worry about, that there are great companies that are on sale at fantastic prices and that logically we should all get a second mortgage to load up on these once-in-a-lifetime bargains. There is no need to panic... 

Hmm...sound vaguely familiar? 

Although there are new behavioral sciences that help explain why investors do what they do, it boils down to the fact that human nature is basically, immutable. Given the same scenario, investors will act in a similar fashion; each time, every time. 

When the crowd is clamoring for the fire exits, the logical part of the brain is switched off. Safety first, Excel spreadsheets...later. 

So when the next financial crisis or disaster hits and investors start eyeing the exit signs, how can we escape from another Groundhog Day scenario? [2] 

Designing a lifetime portfolio is challenging enough - it’s the "sticking with it" part that is the most difficult. 

Even the most knowledgeable investors are often led astray. Certainly the internet could be partially responsible for exaggerating market volatility. It is said that the great thing about the internet is that allows us to make the same bad investment decisions faster than ever before.  

As the last financial crisis in 2008 - 2009 showed us, when the U.S. stock market dropped 57% in a just a few short months, there was no lack of information on the internet, in the newspapers or on the 6 o’clock news. 

Lots of information but not enough wisdom. 

Given all of this "information" many investors sold out at the very bottom only to see their (former) investments soar in value shortly after selling them. Two years later, the market approaches record highs and yes the average investor has decided he needs to get back the money he lost by plunging back in the markets right at the tippy-top of the market. Now we know why the average investor manages to lose as much as 5% a year. 

Certainly it is an epiphany to find out in empirical terms just how much inappropriate investment behaviors can reduce or in some cases, destroy returns. 

There are a few major takeaways I have drawn from all of this research: 

1. The prime determinant of investor return is not necessarily the investment.

2. Inappropriate investment behaviors can easily reduce/destroy a portfolio's return.

3. An advisor can make the difference. 

The above conclusions are certainly not earth shattering. Although the empirical research indicates that the average investor does not do very well, we have to ask the question Why not? How is it humanly possible to have a worse return than the investments that you own? 

The key point here is inappropriate investment behavior. Behavior it appears is far more important than we thought. So, yes it is humanly possible to underperform one's own investments. 

As flawed creatures that we are, how can we enhance investment returns given that our very own human nature may be our own worst enemy? 

We do have a clue. The same research indicated that dollar cost averaging our investments not only matched the investment's return but enhanced it by 0.25% per year. At first glance, this does not sound like much but that is some 5.25% higher than the average investor who may be underperforming the benchmark by a staggering 5% per year! 

[Editor's note: dollar cost averaging refers to the investment strategy of investing the same amount of money at fixed time intervals whether or not the market is going up, down or sideways.] 

We know that dollar cost averaging works but the primary reason why it works is that it ignores what the market is doing - removing the all-too-human stress of worrying what the market might or might not do next.

Although we could all solemnly pledge that we would never again panic during the next market crisis, the truth is that we will panic and be either paralyzed with fear or head once again for the exits. 

There has to be a better way. Here is a possible solution: 

The idea is to set the proportion of different types of investments when the account is started and stick with it. 

The investments can be rebalanced once a year at your annual review with me or can be rebalanced throughout the year by the investment managers. 

There are some sophisticated investments that force one to automatically buy at cheaper prices and sell at expensive prices and reallocate and rebalance as necessary.  

Please see me about these types of investments. 

[1] Source: DALBAR.com 2011 Quantitative Analysis of Investor Behavior

[2] Source: Wikipedia -the phrase "Groundhog Day" has entered common use as a reference to an unpleasant situation that continually repeats, or seems to. See also Groundhog Day movie trailer

 

 
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