Saturday, April 9, 2016

Human Nature and Unnecessarily Poor Long Term Investment Performance ... We're Often Our Own Worst Enemy When We Try to 'Outsmart' the Market

The Big Mistake Investors Still Make tells the interesting but typically sad story of the negative investment results we get when we allow our emotions to rule and engage in the all too typical short term oriented human behavior of following the crowd.

So let's look more closely at what happens when we follow the herd (including listening to too many 'expert' investment advisers who pretend to know the future) and wrongly overemphasize short term market movements --- and end up acting very much to our own detriment by so doing:

"Volatility has taken hold of the financial markets, and it’s likely to bring out the worst in investors.

This year, the S&P 500 index swooned nearly 5% in January, remained flat in February, and surged more than 6.5% for the month of March. That’s after erasing last year’s August-September 8% drop with an 8.4% October gain. . . .

Moves like this drive investors crazy, often causing them to trade their holdings in damaging ways.

Here’s how investors hurt themselves, and what they can do to stop it.
Missing out
Fund-research firm Morningstar Inc. has the data to prove investors’ self-defeating behavior, in the form of a metric called “investor returns.”

An investor return differs from a fund’s total return in that the total return assumes a buy-and-hold approach. The total return doesn’t reflect money moving into and out of the fund, and, therefore, judges the manager’s performance accurately.

But an investor return . . . accounts for cash flows into and out of a fund, and evaluates how much of the fund’s return the average dollar invested in the fund has extracted. In other words, it shows how well or poorly investors trade their funds.

For example, if a fund’s investor return is less than the total return, fewer dollars participated in the fund’s upswing and more participated in the downswing.

This can happen because investors have sold a fund near its lows, leaving fewer dollars in the fund to take advantage of the upside, and bought it near its highs, pushing more dollars into the fund to inadvertently capture its downside.

Sadly, this kind of negative “return gap”—lower investor return than total return—is the norm. Morningstar’s data shows investors in diversified U.S.-stock funds (those not limited to a particular sector of the market) have missed nearly 1.8 percentage points of the funds’ annualized total returns over the past decade because of bad trading. The gap over the past 15 years is negative 1.6 percentage points, implying investors are getting worse at timing their trades.

If 1.8 or 1.6 percentage points doesn’t sound like a lot to give up, consider how much just 1 percentage point a year can cost you over a lifetime of saving. Investing $5,000 a year for 40 years and earning a 6.5% annualized return results in nearly $880,000. Investing the same amount over the same period but earning a 5.5% annualized return results in about $680,000. So in this case, losing 1 percentage point of annualized return due to bad trading would cost you 23% of your potential final sum. . . .

When the market is going up, people tend to feel confident and fool themselves into thinking they can handle any risk. Then, when the downturn arrives, they find they didn’t plan well enough for how they would feel with losses mounting in their portfolios. . . .

Besides anticipating how a downturn will make you feel, try to remember how social a creature you are. There’s little doubt most of us are wired to be with each other, but this characteristic can hurt us in some ways, including as investors. . . .

Be mindful of how much you may be influenced by social pressure, and try to stick to a prearranged investment plan."

Summing Up

Individual investors often are their own worst enemies.

In my case, I know that I don't know when the prices of the diversified basket of blue chip dividend paying stocks that I own will increase in price.

Nor do I know when they will fall in price.

But I do know that over time stocks, unlike other investments, will increase in price at an annualized rate much greater than inflation. They always have, and I believe they always will.

So through thick and thin, I have long owned shares of good solid companies, and it's worked out very well for me.

My view is that it would work well for others too.

Thanks. Bob.

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