The stock market hit a new all-time high again this week. And 2018 is shaping up to be another record-breaking year.
The media and investors are ecstatic. But they shouldn’t be…
Retirement accounts should be sporting some healthy double-digit gains over the last year – yet most of them aren’t.
You see, the average investor is still underperforming the stock market… by a long shot. And the reason is simple.
Investors are still letting their emotions get the best of them. They’re buying high and selling low when they should be doing the opposite. They’re letting their emotional bias take a big bite out of their investment returns.
But it doesn’t have to. There’s a way to check your emotional bias at the door so that your portfolio crushes the market’s returns whether it goes up, down or sideways.
The Behavioral Finance Gap
Financial services marketing firm DALBAR tracks individual investor returns against those of the stock market’s benchmarks. It’s been reporting its findings every year since 1994.
The results aren’t pretty. Average investors earn a lot less.
Over the last 30 years, the annualized return of the S&P 500 was 10.16%. The annualized return of the average equity fund investors was 3.98%. That’s more than 60% less than the broader market! It’s even worse when you consider that the 30-year annualized inflation rate was 2.65%…
DALBAR identified nine behavior biases that lead to the shortfall…
- Loss aversion: Investors sell out of fear of losing more.
- Narrow framing: Investors buy or sell an investment without considering the effect on the rest of the portfolio.
- Anchoring: Investors fail to react to changing market conditions.
- Mental accounting: Investors justify holding winning and losing positions.
- Lack of diversification: Investors may believe their portfolio is diversified when it’s not.
- Herding: Investors buy when everyone else is buying and sell when everyone else is selling.
- Regret: Investors let past mistakes influence bad decision making today.
- Media response: Investors overreact to news stories.
- Optimism: Investors are too optimistic about their investment returns.
But DALBAR found that two of them, the herding effect and loss aversion, are the cause of most investment mistakes over time. To put it another way, these two biases cost investors the most money.
But there’s one behavior bias that DALBAR failed to define…
Separating Stock and (Emotional) State
One of the very first lessons I learned on Wall Street was also the most profitable one. I consider it the 10th behavior bias and call it “spousal immunity.” That’s because it prevents you from saying or seeing anything wrong with an investment.
I was told to “never marry a position.”
What it means is that you shouldn’t fall in love with a stock, bond or any other type of investment for that matter. Just because you like the company’s product, its story or even its commercials on TV doesn’t make the company a good investment. If you don’t get attached, you’ll be disciplined enough to let your winners keep on running. And you’ll be able to cut your losses if a position goes the wrong way – before those losses multiply.
Even experienced investors, myself included, sometimes find it difficult to adhere to this tried-and-true advice.
We’re only human. And no matter how hard we try, emotions like fear, euphoria or panic are going to influence our decisions. These actions can and will have a negative impact on growing your wealth if you let them get the best of you. Make too many of them and they could even delay your retirement.
The first step is awareness. And the second step is sticking to an investment system. This will help remove the emotion out of trading.