The studies prove we’re terrible investors — how a good game plan can make you the exception
Last year, the S&P fell 4.38%.
How’d the average investor do? About the same? Maybe slightly better?
Twice as bad.
The average investor lost 9.42% in 2018.
The reason is — statistically — we’re terrible investors.
This unfortunate reality is the takeaway of research done by Dalbar Inc., a company that studies investor behavior and their market returns.
Year-in-year-out, the results are the same — the average investor performs significantly worse than the market.
Today, let’s begin fixing this.
Over the past week, Louis Navellier has been running a special collection of essays called the “Peak Performance Series.” In it, he’s been tackling the psychology behind investing, shining a spotlight on the most common “behavioral finance” blunders that trip us up and result in poor investment returns.
We’ve received so much great feedback on the series that I wanted to bring the highlights to everyone so you can identify your own blind spots — and more importantly, how to begin fixing them.
As you read the various biases below, ask yourself to what degree you’ve fallen victim to these biases. It’s a great beginning point for smoking out your own personal weaknesses and becoming a better investor.
… overconfidence refers to the phenomenon that people’s confidence in their judgments and knowledge is higher than the accuracy of these judgments.
Put more simply, overconfidence blinds you to the reality of your ability and the circumstances around you.
Nearly all of us fall victim to overconfidence. In his essay, Louis gave the example of the latest Retirement Confidence Survey by the Employee Benefit Research Institute. It found that two out of three workers are confident they are doing a good job saving for retirement and know how much they will need to save to live comfortably.
But the truth?
Only 42% have even tried to calculate how much money they will need!
This makes no sense. Without crunching the numbers, how could anyone say they’re doing a good job? They’re making a huge assumption with zero supporting data.
How certain are you that your portfolio is on target to help you reach your financial goals? Is that certainty rooted in cold, hard numbers or a vague sense of confidence?
***The Disposition Effect Bias
Investors tend to cash in gains far too soon and hang onto losers far too long. This is the result of “Disposition Effect Bias.”
In one study, researchers noted the reality of stock market momentum — basically, stocks that have done well over recent months tend to keep doing well over upcoming months; and stocks that have done poorly over recent months tend to keep doing poorly over upcoming months.
Given this, the rational investor would keep the winners and sell the losers. Of course, we tend to do the opposite due to greed and fear.
As you look in your portfolio today, which “losers” are you still holding? Which “winners” are you considering selling? Is your logic for both potential decisions sound?
Louis begins describing this bias by noting how, in post-game interviews with athletes, the winners will often praise their team effort, while the losers will many times blame the officials or something other than taking direct responsibility.
We see this type of thinking a lot in investing. We also have a tendency to congratulate ourselves for our brilliance when we succeed — but blame outside influences for our failures …
In my office, we refer to this as “confusing a bull market for brains.” A potentially fatal side effect of this all-too-human trait is what happens when we get good results from bad decisions: We do the same thing again, usually to a bad outcome.
As you look at your portfolio and your investment decisions, was it truly your expert analysis that led to your winners? And was it truly external, out-of-your-hands influences that resulted in your losers?
If you decided to take complete accountability for all outcomes, how would that change your next stock purchase or sale?
Louis begins to explain this by calling back to 100,000 B.C.:
… you and your hunter/gatherer tribe are out and about … you see three dozen terrified members of your neighboring tribe running for their lives … Your instincts will tell you to run like the wind. Your instincts will say there’s a good reason three dozen people are running for their lives. It doesn’t matter if you can’t see a saber-toothed tiger or a rival tribe with spears … you just know it’s time to run.
As humans, we have “survival” coded into our DNA. This spills over into our investment choices, think “financial survival.” When we see the crowd taking part in a certain investment, we believe there must be some wisdom in that decision. But is that always the smartest move?
There’s an easy way to resist our tendency for crowd-seeking, and it’s to look for buys when a stock has become a bargain. And I don’t just mean “cheap”; I mean a good value.
In other words, look for a company that’s still growing like crazy — in terms of sales, operating margins, and especially earnings. Whenever its stock experiences a sell-off … then that’s a great opportunity.
Do you have a plan like this in place to help you avoid following the herd?
Present bias is when an investor chooses the “sooner” options between two prospective choices. When it comes to our money, this typically means we choose the “sooner” pleasure of spending what we have today, versus the “later” option of investing it, being patient, and letting it compound for tomorrow.
Americans would rather spend the money they have now than wait, even though saving it would mean having a comfy, stress-free retirement later …
Of course, this goes far beyond just saving for retirement. In everyday investing, the investor may take their profits in a stock too soon when it grows a little volatile, even though the company’s fundamentals are still perfectly healthy and growing. Or they invest too early because the financial media is hyping the stock up. As a result, they overpay for the stock and are stuck with it when folks lose interest.
One of the best ways to avoid this bias is by adopting a plan. Do you know how much you need to set aside for savings and investment today? How much does that mean is left over for you to spend on everyday purchases right now?
Louis begins describing recency this way:
… you certainly understand Recency Bias if you’ve ever had an annual performance review at your job.
Odds are that your supervisor remembers a lot of what you’ve done in the last month but can’t remember work completed nine months ago. As a result, you’re more likely to be judged for the last month, than the last year.
And this same bias is likely affecting your portfolio, too.
We often extrapolate the direction of a stock or an entire market far out into the future, dismissing the potential for it to change directions. Now, while there is some value in momentum investing, blindly adhering to recency bias can result in major portfolio damage. Just think of the Dot-Com investors who believed the tech bubble would continue expanding in 2000/2001.
Are you holding on to certain investments simply because they’ve been climbing recently? If so, is that alone a good enough reason to have them in your portfolio?
***What can we do about these biases?
Well, what do they all have in common?
They involve our emotions.
So, what’s one of the best ways to bypass our emotions?
Have a specific plan, rooted in fundamentals, and stick to it regardless of what our emotions are telling us to do.
That’s Louis’s approach:
I’m a numbers guy. Always have been. Since I was a kid, I’ve loved math and I knew that math was the right way to understand the world.
Said another way, I depend on evidence for my decisions.
I depend on an objective set of criteria that signals what I should buy, when I should buy it, and when I should sell and collect the profits.
Is this your approach, or are you closer to “winging it”?
If you’re not sure the best way to approach the markets, Louis has been working on a mathematic approach for years, which he released in a live event last week — it’s called Project Mastermind.
It’s a market approach that combines technology and data to identify the stocks poised to push higher — with the gains coming in months, not years. If you’d like to learn more, click here.
Regardless, better investing begins with understanding your own weak spots. The biases we covered today affect a huge volume of investors. Which ones hit closest to home for you? How are you going to address them?
Have a good evening,