Why We're Lousy Investors

Despite the best efforts of the financial services industry, not to mention the coterie of press outlets slavishly devoted to the professionals that populate the field, investing should not be very complicated. We can break down the process into six steps:

1. Figure what you are trying to accomplish and be concrete. For example, “I want to save for retirement so that I can live the same way that I live today”, or “I want to fund two years of my kid’s college education” or “I want to save $100,000 for a down payment on a home”.
2. Determine how much money the goal will require (choose from the myriad of online calculators) and then see how much money you have available to fund the stated goal.
3. Measure how much risk you can manage on the way to achieving your goal -- try a few different risk assessment tools to assist.
4. Create an asset allocation plan of assets that act differently when markets zig and zag. Don’t fret too much about creating the “perfect” model, because as noted in the Financial Times “the precise asset allocation model you use is less important than keeping control of fees.” In general, index funds help limit fees.
5. Stick to the allocation by rebalancing on a periodic basis (annually, semi-annually or quarterly).
6. Shift the allocation as your goal nears or if circumstances in your life change.

If only it were so easy! The problem is that we are human beings and as such, we have these darned emotions, which can often lead us astray at the wrong times and make us lousy investors. A recent article “Understanding Behavioral Aspects of Financial Planning and Investing” in the Journal of Financial Planning outlined the issue perfectly: “Emotional processes, mental mistakes, and individual personality traits complicate investment decisions.”

Do they ever! Because of hard-wired tendencies to fall prey to fear, greed, doubt and even regret, many are not inherently rational when it comes to managing money. The emotional aspect to investing explains why in countless studies, mutual fund investors significantly underperform the S&P 500 stock index. The most recent Dalbar Quantitative Analysis of Investor Behavior study found that the average stock fund investor lagged the S&P 500 by 4.2 percentage points per year from 1994 to 2013. The reason is easy to understand: When markets are soaring, investors feel invincible and when they are plunging, they erroneously believe everything is going to zero and bail out.

How can you avoid being a lousy investor? Start by coming clean. Right now, when markets are in decent shape and nothing frightening is occurring, take a look back at your investor behavior. Over the past ten years, have you been reactive to events or have you mostly been able to stick to the six steps outlined above? Are you generally worried about your investments? Some degree of worry is healthy, but you know the difference between a healthy respect for the volatility of markets and the anxiety that robs you of sleep.

If you are concerned about your ability to weather the next market downturn without shooting yourself in the foot or are plagued by self-doubt about your investments, then go back to the drawing board and see if you can auto-correct by walking through the six steps.

But investing is not for everyone. The authors of the Journal of Financial Planning article quote Benjamin Graham, the founder of security analysis, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” If you fear that you may be your own worst enemy when it comes to investing, there is no shame in seeking the assistance of a qualified financial planner.

I suggest that you stick to an advisor who is a fiduciary; that is, one that is obligated to put your needs before hers or before her firm’s. Two of the designations that hold its professionals to the fiduciary duty are the Certified Financial Planner (CFP®) certification and CPA Personal Financial Specialist (PFS).

Dumb Things Retirement Investors Do

My stomach sank when I read this headline: “Retirement Investors Flock Back to Stocks”. The article began with a declaration that should invoke fear in every market observer, “Retirement investors are putting more money into stocks than they have since markets were slammed by the financial crisis six years ago.” According to new data from Aon Hewitt, stock investments accounted for 67 percent of employees' new contributions into retirement portfolios in March, the highest percentage since March 2008. The article highlights a number of retirees, including one should be the poster child for why investors should avoid market timing. Roy put all his retirement assets into cash in May 2008 and over the past six years, has gradually increased his total stock allocation to 80 percent.

Let’s review that decision for a moment: Roy may have missed the worst part of the crash (the stock market bottomed in March 2009), but he also missed a good chunk of the stock market recovery. And I am doubtful that he employed a disciplined approach to rotating back into stocks. My guess is that he accelerated his stock purchases only after the market had gone up.

Economists call this “recency bias,” which means that we use our recent experience as a guide for what will happen in the future. So when stocks are soaring, we think markets will keep rising, but when the market plunges, we become convinced that it will never rise again.

Not surprisingly, the Aon Hewitt report underscores investors’ recency bias: At the stock market's peak in October 2007, investors put 69 percent of new 401(k) contributions into stocks. After the index lost more than half of its value over the next year and a half, frightened investors sharply reduced their allocation to stocks to 56 percent in March 2009, when the market hit bottom.

Over the past five years, the index marched higher and fear receded, allowing investors to slowly put money back into the market. Though as recently as last year, a whopping 76 percent of respondents told Bankrate.com that they were just saying "no" to stocks. Funny how a year of 30-plus percent returns can encourage retirement investors to rediscover their love of stocks!

This type of erratic investor behavior is actually quite common. Year after year, research from Dalbar analyzes the difference between how investor returns compare to major indexes and the news is not very good. According to Dalbar’s latest Quantitative Analysis of Investor Behavior study, despite some improvement, mutual fund investors have significantly underperformed the S&P 500 over the past 3, 5, 10 and 20 years. The average stock fund investor lagged the S&P 500 by 4.2 percentage points per year from 1994 to 2013.

Investors underperform for a simple reason: they jump in and out at the worst moments. Of course, only with hindsight do we understand that it was the wrong time. And sometimes, market conditions can lure us into thinking that nothing bad can happen. To wit, it’s been three years since the S&P 500′s last correction began. Since the summer of 2011’s 19.9 percent swoon, the S&P 500 has not experienced a correction of more than 10 percent. Sure, there have been pullbacks (the most extreme of which was the 9.9 percent drop in the Spring of 2012), but none of which lasted long enough to spook investors.

Nobody knows when the next correction is coming, but rest assured, it will arrive at precisely the wrong moment. Investors can protect themselves from the insidious trap of buying high and selling low by diversifying their portfolios, which can help them avoid doing dumb things with their money. As Benjamin Graham, the founder of security analysis, said in his 1949 masterpiece, The Intelligent Investor. “The investor’s chief problem – and even his worst enemy – is likely to be himself.”