How Investors Are Still Killing Their Returns

I subscribe to some investment newsletters that deliver the latest headlines each day. I was very excited a while back when I read about the billions of dollars pouring into low-cost index funds. Which means that’s billions of dollars pouring out of actively managed mutual funds that:

  • Come with costly yearly expenses compared to similar low-cost index funds
  • Have been proven by academics to underperform the stock market average over time

At the same time, I thought I would be out of a job because if everyone moves into index funds, I’ll have less to talk about.

But a conversation with a financial advisor revealed to me people hadn’t gotten the complete message. While people are making better investment choices, they aren’t sticking with their plan.

  • Investors are still chasing returns – but with index funds
  • Investors are still trying to time the market – but with index funds
  • Investors are still taking on too much risk or not enough risk – but with index funds

How to build wealth

The key wealth builders when it comes to investing remain unchanged:

  • Proper asset allocation – taking enough risks with your money, so you make enough money to meet your financial goals
  • Diversification – investing in lots of stuff to reduce risk
  • Sticking with your plan
You could be in the most expensive investments available instead of low-cost index funds and do better if you stick with your plan compared to someone who changes course every year.

However based on academic research you will do best if you go with low-cost index funds and stick with your plan.

Chasing returns

The average investor earns much, much less than the stock market average.

If you had $100,000 ten years ago, you probably cost yourself $78,000 because of poor investment decisions.

Why? The primary reason is changing your investment strategy because of impatience, overconfidence, or following the crowd.

When co-worker Bob buys everyone pizza on Friday because his investment scored him a win, everyone thinks Bob is brilliant. Let’s invest like Bob does!

When you did deeper, though, Bob just had some recent luck. Looking at his long-term track record, you’ll find Bob sucks as an investor.

I should know – I used to be Bob. It’s how I lost $40,000 in the stock market.

According to a study by DALBAR the average mutual fund investor underperformed the stock market by nearly 5% over the past 20 years.

Sure, there are a few people who beat the market occasionally. It doesn’t make up for the 20-year average underperformance, though.

Timing the market

You and I are emotional people. If we had no emotion like Mr. Spock on Star Trek, investing would be a breeze. When the market tanks on a Monday, we would go about our business and not think twice about it.

Unfortunately, most people aren’t like that. Especially DIY investors. They get scared, cash out, buy gold, or stuff their money in a savings account.

Savings accounts lose money because of inflation (3% a year on average). You run a bigger risk of doing nothing with your money than investing.

Timing the market‘ is the belief you or a highly paid professional has some crystal ball and can predict when the market will go up or down. Spoiler alert: you can’t.

A lot of people would like you to believe they can because maybe they got it right once or twice in the past. Suddenly they are a guru!

I’m a guru too

I predict sometime in the next coming decades the stock market will crash. I also predict sometime over the next twelve months it’s going to snow in Boston. When it does – remember you heard it here first.

The stock market always goes up and down. Sometimes by a lot. But over a period of decades – it’s always gone up. In fact, if you look at any ten-year period of the stock market, it’s been up 95% of the time. Over any 15-year period – up 100% of the time.

If you invest in a low-cost index fund that mirrors the stock market, you’ll have more money 15 years from now (based on history, which is all we have to go on).

A study of 66,4000 investors compared the active traders to the buy-and-hold traders – those who didn’t try to time the market – and found the active traders earned 7% less!

The best way to time the market is to be in the market all the time.

Too Much Risk. Too Little Risk.

If you invest in things that offer big returns but come with big risk, you can end up with less money than if you invest in things that have lower returns and lower risk. How’s that?

In the 2008-2009 market crash, people who invested heavily in stocks (higher risk) lost considerably more money than people invested in stocks and bonds (lower risk). And while the people who invest in stocks and bonds don’t make as much money year after year, they don’t lose as much money when the market tanks.

Here’s a very simplistic example:In 2008-2009 the stock market dropped 50% over an eighteen month period.

If you had $100,000 in the stock market in 2008, eighteen months later you had $50,000.

If you had $50,000 in the stock market in 2008 and $50,000 under your mattress, eighteen months later you had $75,000 total. That’s because your stocks lost half their value ($50,000 became $25,000).

While you would not have made as much over time because you only had half your money working for you in the stock market, you didn’t lose as much.

And it’s a lot easier to go from $75,000 back up to $100,000 than it is to go from $50,000 back up to $100,000. It’s easier to recover from your losses if you pick investments that balance risk and return based on your financial goals.

On the flip side, if you don’t invest in the stock market, you run the risk of losing buying power because of inflation. Investments have to make at least 3% a year just to keep up with the average rate of inflation.

There are investors out there that are getting into these high risk/reward index funds (emerging international markets for example), and they aren’t offsetting them with lower risk/reward investments.

Take too much risk and you can’t recover. Take too little risk and you run out of money.

What Should You Do?

When I started investing, I made all these mistakes. Then I discovered and bought into the philosophy of investing for the long haul and ignoring the media. That’s when my investments started making me more money.

Are you making any of these investing mistakes? If you are, think about if the plan you’re following is wrong, or is it just your ability to follow the plan.