The following is an excerpt from 20 Retirement Decisions You Need to Make Right Now Over the next few days I'll be posting all of the 10 most common investor mistakes, so stay tuned to see them all.
Max Haley has been investing in the stock market for the past twenty years. In 1989, at age forty, he started with $50,000. Since then, he has invested in a number of individual stocks and stock mutual funds. Max prides himself on his “investment expertise.” To determine what stocks and funds to buy, when to buy, and when to sell, he reads Money magazine, subscribes to The Wall Street Journal, frequently visits investment Web sites, and tunes into CNBC several times each day to obtain stock prices and reports.
So how’s he doing? By the end of 2008, his investment had grown to $114,532. Max’s annual return was a meager 4 percent. Had Max simply invested his $50,000 into a balanced stock and bond mutual fund and never looked at it again for the twenty years, he would have more than doubled his returns and ended with $245,118.
If Max retires and wants his nest egg to last thirty years he can withdraw only $6,400 each year. If he annually withdraws 6 percent of his hand-picked portfolio it will kick off about $10,000 per year. If he had simply invested in the balanced fund, assuming returns similar to those the fund produced in the past, he could pull out $20,500 each year. What’s really surprising about his performance is that Max’s 4 percent annual return was better than what the average U.S. stock investor earned during this same period!
After applying so much effort, why did Max do so poorly? Max, like most individual investors, was guilty of making ten mistakes. Had he read and applied the lessons you’ll learn in this chapter when he started in 1989, he likely would be sitting on a much larger nest egg today.
Mistakes Will Cost You
And no doubt about it: You will need a large nest egg to retire on. Social Security is under pressure as more and more baby boomers start tapping into the system. Companies are eliminating traditional pension plans. More than ever before people need solid returns from their own investment portfolios in order to produce a livable retirement income. Plain and simple, your success as an investor may well dictate whether or not you reach your retirement goals.
In the future, savings and investments will take on an even greater importance. This is a huge problem for most retirees. Why? Because most people—including, most likely, you—simply don’t invest very well.
A twenty-year investor study dramatically illustrates the grim lack of success many investors have experienced. According to the study, the average stock-fund investor achieved returns of only 1.87 percent a year from 1989 through 2008. Had these same investors simply invested their money in the S&P 500 Index (composed of large U.S. company stocks) and forgotten all about it, they would have achieved an 8.35 percent annual gain. Even bonds beat most investors, growing 7.43 percent per year. The stock market provided results almost five times better than those experienced by millions of stock mutual fund investors! It should have been easy for even the average investor to make substantial sums of money over this period of time.
Consider for a moment the difference between an investor earning an average annual return of 1.87 or 7.43 percent as opposed to an investor earning an 8.35 percent return.
Over the long run, even during bull markets, most investors struggle to obtain performance better than low-yielding investments, like money markets and certificates of deposit, because they make common investor mistakes. How is it that investors do so poorly at times when investments are doing so well? No single mistake explains this poor performance. Rather, there are a combination of errors repeated over and over—mistakes that can be overcome by simply implementing and adhering to a disciplined investment strategy. (Developing a strategy is discussed in the following chapters.)
In this chapter, you will learn that it’s possible to obtain good long-term returns by avoiding the obstacles that plague so many investors. By avoiding common mistakes, you will be in a better position to reach your retirement goals. Here are the ten most common investor mistakes.
Mistake 1: Excessive Buying and Selling
Like the amateur chef that continually seasons food until it’s inedible, investors who are overactive in their trading undermine their goals.
A study of more than 66,000 households with investment accounts at a well-known brokerage firm found that investors who traded most frequently underperformed those who traded the least. For the study, the investors were split into five groups based on their trading activity. The returns achieved by the 20 percent of investors who traded the most lagged behind the least active group of investors by 5.5 percentage points annually.
Another study showed that men trade 45 percent more actively than women, and consequently, women outperformed men.
Many investors make the mistake of thinking that the more often they trade, the better their returns will be. The advertisements aired by many discount brokerage firms promoting active trading want you to believe this is true. However, the evidence suggests exactly the opposite. So sit back and relax!
Mistake 2: Information Overload
Too much information can be dangerous to your wealth.
Not long ago at the beginning of an investment seminar, I asked the audience how many knew the previous day’s closing level of the Dow Jones Industrial Average. Many hands went up, and these “smart” investors had no difficulty citing the index’s closing value.
Then I asked who in the audience didn’t have a clue where the market had closed. Timidly, a woman with very little investment experience raised her hand. The crowd was surprised as I handed her a $20 bill. I explained that investors who rarely check the market and the value of their investments keep more of their money invested in stocks, thus they often obtain better long-term results. Those who monitor the market too closely have a tendency to undermine their portfolios with self-destructive behavior.
What role should information play in your investment decisions? University of Chicago Professor Richard Thaler, the father of behavioral economics, conducted an experiment to see how much investors would allocate to stocks and bonds based on how often they reviewed their investment performance. Three simulations were developed, each representing a different frequency of investors reviewing their portfolio performance over a twenty-five-year period.
Those participating in the study were assigned to participate in one of three simulation groups. Group A was bombarded with investment performance information. Their test simulated the experience investors would have if they looked at the performance of their investment portfolio every month for a twenty-five-year period. Group B received performance information replicating the scenario of looking at their investments just once each year. Group C received investment updates only once every five years. Which group do you think did the best?
The investors who received the most performance information allocated the smallest amount of their portfolios—about 40 percent—to stocks. They not only maintained the lowest equity exposure but tended also to sell stocks immediately after a loss. The group that received updates only every year devoted 70 percent of their portfolios to stocks, while those who received performance information every five years invested 66 percent of their portfolios in stocks. And, as we all know, based on the history of the market, investors with greater exposure to the equity markets have enjoyed far better long-term performance than those with lesser exposure.
The bottom line: The more closely investors follow the market, the more tentative they become about investing in stocks, which ultimately hurts their returns.
The solution? Develop a fundamentally sound investment strategy and maintain your stock allocation through up and down markets. Stay away from financial sites on the Internet, turn off CNBC, consider canceling The Wall Street Journal, and quit worrying about your investments every day. Professor Thaler said it best: “My advice to you is to invest in equities, and then don’t open the mail.”
Mistake 3: Market Timing
History has shown that the stock market rises about 70 percent of the time. The danger, when investing, is in finding yourself out of the market during the 70 percent of the time it’s going up, all because you’re trying to avoid the 30 percent of the time the market is falling.
Trying to choose the right times to jump in and out of the market is an impossible task. Too many investors make the mistake of thinking they can do it. Investors attempting to time the ebbs and flows of the market tend to jump in too late, missing major upswings, and jump out after the market has fallen. Consequently, many investors end up buying high and selling low, yielding poor results that often lead to the kind of frustration that keeps investors out of the stock market altogether.
If you had invested in the S&P 500 from 1984 to 2008, covering 6,306 trading days, you would have enjoyed a 7.06 percent annualized return. If you had missed the market’s forty best days, your annualized return would have been cut to a negative 0.93 percent! There’s a dramatic difference between an investor who spent 6,266 days invested in the stock market and another who stayed invested all 6,306 days. There is a huge price to pay if you mistime the market.
Market timing is typically driven by emotion. Investors are notorious for buying stocks when they feel good and selling when they feel bad. Think about this; you feel good once the market has run up 20 percent or more and you feel bad when your portfolio is down 20 percent. With the “feel good/bad” investment strategy, you will always buy after the market has gone up and sell when the market has taken a big fall. The biggest days in the stock market normally occur early in a recovery. So if you pull your money out of the market when it’s down and hope that you will be smart enough to get back in the day it hits the bottom and starts to climb, the odds are stacked against you. And if you are late you will likely miss the best days. Following the “feel good” strategy will lead you to poor returns.
Ah yes, got to love the buy and hold strategy the article implies...don't look at trends...don't look at the market...close your eyes and hope. That should be the title of the article.
I also find it interesting the author does not include the banner 2008 stock year in his calculations. If you notice the calculated percentages are from 1984 to 2008 but not including.
Posted by: Joe | September 21, 2010 at 04:35 PM
Great list. These three are definitely mistakes and tough to avoid for a lot of folks. Can't wait to read the rest.
It's amazing that there seems to be three main groups of investors:
1. People who know very little and keep investing simple (investing over time, dollar cost averaging - mostly w/ 401ks and other retirement accounts).
2. People who know just enough to overthink things and get themselves into trouble by overcomplicating investing.
and
3. People who know a lot. Most of those people will come back to keeping investing simple because it's proven to be the best route to success and reduces their time commitment and stress level.
Let's all get to #3 soon!
Posted by: Nick | September 21, 2010 at 05:24 PM
Unfortunately Max Haley's experience is that of millions of investors. Many were told they are in charge of their own investments and given no instruction on how to manage it. Thus, they were easy pickings for stock brokers and insurance salesman. The stock brokers and insurance salesman did well the clients didn't. Wait until the baby boomers really hit and the diaster that the country faces will be realized.
Posted by: DIY Investor | September 21, 2010 at 06:53 PM
LOL, here we go again.
Why does every anti-timer argument immediately go to the horrible logic of the X best days argument. This is a cherry picking rear view mirror fantasy argument?
The sad thing is there are good arguments but once someone uses this one they have decided to use a trick and not engage in the real debate. I guess if they can trick most people with it maybe that's all they care about. As Al Gore has been caught admitting, it's ok to stretch the truth because if the problem is serious enough, you might have to scare people into ignoring the some facts that might keep them from seeing the real "truth"
Posted by: Apex | September 22, 2010 at 01:36 AM
This book was published August 1, 2010. To leave the past two years out of his analysis of the market's performance is misleading at best. Although I tend to subscribe to many of the benefits of buy and hold (and do some trading with a small portfolio), this ommission of data renders the whole book irrelevant.
Posted by: CommRE | September 22, 2010 at 12:12 PM
Yeah, market timing ain't usually such a hot idea. BUT those who
rail against it always talk about missing the 40 (or 50 or 20 or
100) best days of performance. Well, even an amateur market timer isn't
likely to miss the 40 best days without missing some of the worst days,
too, folks! (although someone who took ALL their money out of the market
in the dark days of early 2009, when Jim Cramer was warning of Dow 4000
and worse, probably came close)
Posted by: Harm | September 22, 2010 at 06:00 PM
In the piece FMF states "balanced stock and bond mutual fund". Can someone please give me an example of such a fund or what phrase should I research on?
Thanks.
Posted by: Pierre | September 23, 2010 at 11:49 AM
Pierre --
Actually, this is not from me. It's a book excerpt (written by another author.)
As for your question, I put "balanced stock and bond mutual fund" into Google and came up with this page:
http://www.balancepro.net/education/publications/mutualfunds.html
It offers a pretty good summary IMO.
Posted by: FMF | September 23, 2010 at 11:53 AM
FMF,
Sorry about that. Thanks for the info. I have bookmarked that page and will study it a bit better tonight at home.
Thanks again.
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