Monday, November 3, 2014

Pogo's Sound Advice for Individual DIY Investors .... Don't Let Emotions Get in the Way of Good Long Term Performance

Most individual 401(k) savers and investors don't achieve superior and inflation beating market returns over the long haul because of two simple and easily correctible errors --- fees and emotional buying and selling during periods of market volatility.

The first correctible error most of us make (covered in yesterday's post titled "401(k) Investing the Low Cost, High Rate of Return Way ...") is paying excessive fees paid to the so-called market experts to manage our investments.

But an even more important factor for subpar long term investing performance takes place when we allow short term emotions to overrule what should be the judgment of our more rational long term focused selves.

Pogo captured this all too human tendency to do the wrong things at precisely the wrong times when he said, "We have met the enemy and he is us." {NOTE: We posted on this general topic September 16 in "Three Common and Avoidable Investing Errors ..." urging individuals in times of market volatility to "Stay Calm and Know Thyself."}

But often the best thing for an individual investor to do when the fit hits the shan is to just sit back, relax and do nothing instead of acting emotionally and doing something. Successful investing for the long haul involves a whole lot of 'sitting there.'

So for all the should be sitters, let's update those prior comments on how to avoid inferior investment results.

Because of emotions, individuals tend to buy high and sell low.The stock market has done very well over the past several years, reaching new highs last week. Yet we all know that stock prices don't climb all the time. That's for sure.

So if you've been in the market, stay the course. And if you've not been in the market but want to play the "long game," then buy. But if you're not going to stick around when prices fall, don't invest in the market. It's neither worth the mental anguish for short term players nor profitable when panic strikes in periods of market distress.

Pogo had it right. Buying high and selling low is both a bad practice and habit. Don't do it.

2 Reasons Why Investors Miss Stock Rallies is about setting our emotions aside when making investing decisions:

"Although the U.S. business cycle is in its sixth year of expansion, many individual investors are still reluctant to invest in the stock market. As the chart on investor fund flows demonstrates, retail investors have pulled money out of equities during the current bull market while institutional investors have moved money into the asset class.

The fact that institutional investors have exhibited the opposite behavior of individual investors over the past seven years stems, in part, from the fact that institutions typically follow policy targets, which naturally enforce disciplined investing. Retail investors, on the other hand, too often allow their emotions to dictate their allocations, which can result in ill-timed U.S. equity investments, such as buying high and selling low.


Our own worst enemies

Behavioral finance, a relatively new field of study that combines psychological theory with conventional economics, can explain why retail investors often fail to make optimal investment decisions. Two behavioral biases—the availability heuristic and loss aversion—can partly explain why retail investors have pulled money out of equities in recent years. The “availability heuristic” suggests that investment decisions are made based on easily recallable events. For many, the 2008 financial crisis left its mark on investor psyches because it was unexpected, sudden and dramatic. Despite the slow and steady recovery we have seen over the last five years, the financial crisis has likely influenced decisions by making investors more risk-averse than they were before the crisis. Theories put forth by behavioral finance also suggest that “loss aversion”—when people are more sensitive to losses than they are excited by potential gains—has kept investors more focused on how much they could lose in the short term, rather than on how much they could gain if they stay invested for the long term.

Together, the two behaviors may have contributed to individual investors’ decisions to move money out of equities following the large losses many experienced during the financial crisis, preventing them from benefitting from the subsequent equity rally.

Investment Implication

Understanding the investor biases that are most common in today’s markets can be an important step toward improving portfolio performance. When investors can shake off the behavioral biases that have been distorting their decisions, they may be better positioned to realize improved portfolio performance by taking advantage of long-run expected equity returns."

Summing Up

When we allow our emotions to guide our investment decisions, we tend to react much more negatively to troublesome events than we do positively to good news. Hence, we are fearful of market downturns, both those of short and long duration, and as a result tend to buy high and sell low.

Many people still haven't returned to the market since the dramatic 2008 decline, and many of those same people will now buy, then later get scared and sell when the market falls by 10% or more sometime down the road, which at some point it will.

But over time, stock prices rise. They always have and they always will.

And besides that, nobody can accurately predict two things: (1) when the market will fall; and then (2) when it will thereafter rise again. Accordingly, those who are lucky and sell stocks at the highs, won't successfully buy again at the lows.

Based on the fundamental outlook for sales, earnings, interest rates, inflation and the U.S. economy, the stock market is definitely not overvalued currently, and it's not headed for a long term decline, or perhaps even a short term 'correction,' contrary to what lots of the pundits and market 'experts' are saying.

So let's all avoid experiencing the Pogo effect and refrain from predicting short term market moves. Over the long haul, the unemotional 'just sit there' DIY way is the best way.

That's my take.

Thanks. Bob.

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