Avoid These Ten Examples Of Suboptimal Investor Behavior

[Today’s post is from Wealthy Doc, an MD/MBA who has already reached financial independence. In this article, he discusses some of the common investment mistakes that were cited in the 2016 Dalbar annual report. Wealthy Doc’s made all of these mistakes, and I’m sure many of you have made at least a few of these mistakes as well. This article previously ran on Wealthy Doc’s blog in May 2017. -WSP]

I reviewed my investment return results with a CFP investment advisor recently. I noticed that my return was solid and positive but not as high as the benchmark securities I was trying to match. I asked him why that is. What do you think was his response? It was well, “uhm… uh… well… traditionally that gap is from investor behavior.” He was trying to politely say I suck as an investor or maybe that my hands-on transacting resulted in suboptimal performance (that sounds a little more palatable somehow).

I was reminded of some of the results from the 2016 Dalbar report. They study investor behavior and performance. They found that in 2015 the average equity mutual fund investor underperformed the S&P 500 by 3.66%. While the market gained slightly, the investor actually suffered a loss. How crazy is that? The 20-year annualized S&P 500 return was 8.19% while that of the investor was only 4.67% (a gap of 3.52%).

Well, I guess I’m not alone. That provides some comfort. But why do investors underperform? Well, that could be the subject of an entire book, but let’s take a quick look:

• We are impatient. Equity mutual fund investors seldom stay invested in their funds for more than 4 years. When they do it is usually only in a bull market.
• We are more comfortable with a slow, invisible inflation risk than equity risk. We tend to not allocate enough capital to equities. We hold too much cash and bonds compared to a rational profit maximizer. Inflation is insidious and easy to ignore in the short term. Stock crashes can be large and sudden and affect our reptilian brains more. This makes us “loss-averse” with respect to equities.
• We try to time the market. We think we can tell when profits and stocks will go up or not. Economists cannot. Presidents of nations cannot. Warren Buffett cannot. But somehow, we think we can! Thus, we confidently buy high and sell low.

We do all kinds of crazy and irrational things that lower our results as well:

• We are overly optimistic that a bad company will recover.
• We are influenced by our peers, friends, and media and tend to go with the herd (lemmings off the cliff).
• We remember our painful losses and damage our outcomes to not let that happen again.
• We think we are above average in our ability to select a high performing stock, manager, or fund.
• We are superstitious about big round numbers (such as, “I will shift from stocks to bonds so that I won’t risk going below $1M in assets” or “What will we do if the DJIA crosses 20,000?”
• We don’t understand diversification and tend to under diversify or over diversify.
• We have a home team bias. We underinvest in other economies around the world due to ignorance, bias, or false optimism in continued U.S. success.
• We don’t like tracking error. A well selected, concentrated portfolio may exceed the outcomes of the market but will likely not always be well-correlated. When we underperform the market, we tend to make changes even when it would have self-corrected and then some.
• We don’t give taxes and expenses enough attention. They seem like small percentages. Plus, it is all boring and confusing so we don’t bother.
• We don’t plan our cashflow or expenses well. We often must sell investments to generate cash for some other purpose and/or we don’t have enough cash to invest when opportunities arise.

Ugh. This isn’t even a complete list, but it is enough to turn my stomach. How about yours? Maybe I feel a little bit better now. I am amazed and grateful to be doing as well as I am despite having committed every one of the above listed human foibles.

[I’ve often said that you can win the investing game by not losing. It’s more fun to try to make a “smart” trade than to simply prevent mistakes that erode your returns. It’s more fun to tell your co-workers that you bought Amazon before everyone else or that you sold at the market top / bought at the market bottom than to say that you are staying the course. But the path to investment success is taking what the market gives you, and trying as hard as possible not to give your returns away. -WSP]

What do you think? How many of these common investment mistakes have you made?