Individual Investors Have a Dismal Track Record ... And It's an Avoidable One

The market has going gangbusters --- for the past several years. Where will it go from here? That's a good question. My guess is onward and upward.

But that doesn't mean that most individual investors will optimize their financial performance along the road to retirement. In fact, history teaches that most of us will tend to do the wrong thing by selling when we should be buying and buying when we should be selling. And paying for bad advice from the 'pros' all along the way.

In other words, what far too many of us as individual 'long-term investors' won't do is exactly what we should do --- stay the course. Yesterday we wrote about the difference in achieving 2% or even 4% incremental investment returns over a long period of time -- 36 years -- which we used as the average career of a typical American worker. After reading this, you may wish to refer to that earlier post again, because knowing how the rule of 72 works can perform its magic for you, too.

{NOTE: Yesterday's post was titled 'The Keys to Successful Pension Funding and Individual 401(k) Retirement Investing Can Be Summed Up in Three Words .... Rule of 72'}

Joining the Bandwagon? Don't Lose Your Balance has the story behind the story of individual investors and their tendency to do the wrong thing consistently when investing for the long run:

"STOCKS are back. And that could be dangerous.    

Graphic

Buying High and Selling Low

“This is one of those moments,”said Louis S. Harvey, the president of Dalbar, a research firm in Boston. “It’s one of those times we warn about year after year.”. . . 

 

The Dow Jones industrial average set a new closing record on Tuesday — and climbed even higher the next day, and the next day, and again the next. The Dow has risen nearly 10 percent in this young year alone. In the four years since stocks hit bottom in March 2009, their prices, on average, have more than doubled.

 

Already, fund flow data suggest that people who were frightened away from stocks after the catastrophe of 2008 have begun buying again this year. And no wonder. The stock market has been a marvel to behold.

 

What would Mr. Harvey tell someone who wants to start buying now, after sitting on the sidelines for the last four years?

 

“I’d say, if you can reliably predict where the market’s going, then jump in feet first — just buy, buy, buy,” he said. “But if you don’t know what the future will be,” he added, caution is the wiser course. Before plunging into the market, he said, “make sure that you select a reasonably defensive asset allocation strategy first.”

 

If stocks are irresistible to you, set up a balanced and diversified portfolio containing many different stocks and bonds, he continued. “The most important thing, once you have a strategy,” he said, “is to find a way to actually stick with it.”

 

He has seen soaring stock markets before, and, for the typical mutual fund investor, they have often gone badly. When the market is already high, Dalbar has found, many people start to buy. When it’s already fallen, they sell.

 

The dismal truth is that over the long run, the average person is a woeful investor, regularly losing money to more skillful traders. Dalbar performs an annual survey of actual investor returns in mutual funds, and compares them to the return of the overall market. He shared the latest, still unpublished figures  . . .. They tell a sorry story.

 

Over the last 20 years through December, the average return of all investors in United States stock mutual funds was 4.25 percent, annualized. Over the same period, the benchmark Standard & Poor’s 500-stock index returned an annualized 8.21 percent. That’s a huge gap — nearly four percentage points a year over two decades. . . . 

 

Why is the gap so wide? One reason is that after fees and expenses, the average mutual fund manager doesn’t beat the overall stock market, as many studies have shown. But that explains only part of the problem. The rest of it, Mr. Harvey said, is that investors themselves “move their money in and out of the market at the wrong times.”

 

“They get excited or they panic,” he added. “And they hurt themselves.”

 

It’s not that stocks are a bad idea in themselves. Holding a diversified group of stocks — along with a broad collection of bonds — has paid off for most long-term investors, Mr. Harvey and a large majority of strategists say. Stocks have outperformed bonds over the long term, while bonds have provided steady income and more reliable day-to-day returns.

 

Combining stocks and bonds, maybe with other assets, can create a less volatile portfolio, letting an investor sleep more peacefully. The question for most people isn’t whether to own stocks. It’s how to allocate them intelligently, as well as when to buy.

 

I asked Ed Yardeni, an independent economist and market strategist who has been bullish on stocks for four years, whether it makes sense to start buying now. “Obviously, it would’ve been better to buy them in March 2009,” he said. “But buying now still makes sense if you believe we’re in a secular bull market” — a market that will keep rising for a long time.

 

Mr. Yardeni assigned what he called “a subjective probability” of about 60 percent to that optimistic outcome. He said factors like growing energy independence in the United States and a “technological revolution that has never stopped” could help propel the domestic economy forward, bolstering corporate earnings growth and providing fundamental support for stocks. For the short term, he said, the expansive monetary policy of the Federal Reserve and other central banks is acting as a tonic for the stock market, and fear of disaster in Europe has abated.

 

"But there is still a sizable risk that the economy and the market could unravel, he said. “You want to be diversified,” he said. “You don’t want to just hold stocks. Even so, he said: “You do want to hold some stocks. You’re getting nothing for cash, and at some point bond yields will rise and there will be big losses in the bond market.”. . .

 

Joseph H. Davis, head of the investment strategy group at Vanguard, said that “chasing stock returns when the market is setting records is obviously not a smart strategy.” He would urge anyone tempted to do that “to consider what their risk tolerance really is — and how they’d feel about their portfolio if we have another year like 2008 — because even if it won’t be exactly the same, something like it will eventually happen again.”

 

Mr. Harvey of Dalbar also suggested that investors try to keep the bad years in mind before committing heavily to stocks."

 

Summing Up

Know thyself is always advice worth heeding.

And for individual savers and investors, it is especially good advice to follow.

Therefore, knowing how most individual investors tend to shortchange themselves by engaging in unnecessary and self defeating behavior is knowledge well worth taking the time to acquire.

And knowing how to beat the pros and other individual investors by a wide margin is knowledge well worth having as well.

So knowing how simple it is to achieve incremental investing returns of 2% to 4% annually over a long period of time is worth getting.

It will help us to secure both a solid retirement income and enjoy a financially worry free life as oldsters.

Accordingly, taking the time to learn how easy this all can be is perhaps the best kind of investing knowledge of all.

It's knowledge that, once we have it, we can impart to our kids and grandkids as well.

And it's all embodied in just three simple words --- Rule of 72.

That's my take.

Thanks. Bob.