Are you a typical investor? Research shows that the average investor in the United States significantly underperforms when compared to broad indexes such as the Dow Jones Industrial Average (Dow Jones) or the Standard and Poors 500 Index (S&P 500). Read the article below to find out the five main reasons for this disappointing phenomenon - and to make sure you don't fall into the same trap.
Too Many Investors Stink at Investing
Research shows that individual retail investors are not doing a good job at investing. Much research has come out showing that retail investors, on average, get much less than the overall market for the same level of assumed risk. This is ridiculous. This means that retail investors don't beat an index such as the Dow Jones Industrial Average (Dow Jones) or the Standard and Poors 500 Index (S&P 500). Instead, retail investors earn half of the return of the broad indexes on average.
If this doesn't surprise you, it should. How can the average investor earn half of a broad market equities index such as the Dow Jones or the S&P 500? Why wouldn't that "average" investor just invest in the index and get the index return? The reason must be because investors don't just invest in the index. They must do something else on average or else they would at least get the average index return minus trading fees and other incidental fees. Below are the five main reasons your or an average investor (hopefully you're an above average investor) fails to do well and fails to beat index returns.
1. You Trade too Often
The first reason that the average investor underperforms the market is because he or she trades too often. As we said above, if you just invest in the index you'll get the average index return minus any trading and incidental fees. There's a caveat there, however - you have to stay invested! You can't go in and out of positions consistently. By trading too often, you incur more fees and fees can really add up and eat away at your potential wealth.
For example, say an investor invests $750 a month in the stock market and the transaction fee is $7.50 (a reasonable amount at the time of the writing of this piece). That $7.50 will equal 1% of the investor's monthly investment, a non-trivial amount. If our hypothetical investor invests every single month and doesn't sell, he or she will have paid out $90 in fees. This is reasonable.
If, however, our investor is more erratic and buys and sells in a futile attempt to somehow time the market, he or she will pay a lot more in fees. Let's say the investor buys every week instead of every month, splitting his or her $750 monthly investment into $187.50 weekly investments. Additionally, our frantic investor also sells some amount every month. It doesn't matter how much he or she buys and sells in reality because most modern brokerage fees are usually flat (instead of a percentage of the invested amount). So, now we have the following costs:
Now, many investors don't invest $750 a month. Many invest more, but many invest less. Some investors can only invest $100, $200, or $300 a month. For them, the above situation would seem like a dream. For them, trading as often as the frenetic investor above would absolutely devastate their portfolio, requiring consistent extraordinary returns just to break even.
By trading too much, you put the breaks on your portfolio's growth. You might think you know what you are doing (eg. timing the market) or you might be scared of a downturn so you pull out for a while when the market dips, but all of that is incorrect for most investors as evidenced by their abysmally low performance as compared to a broad market index. For most investors, trading too much isn't a good an idea. They should stick with a good and suitable strategy and stay invested even if the market goes day. They should not be overconfident in their ability to predict price movements, understanding that there are thousands of well-trained, highly educated, and high-incentivized market participants attempting to do the exact same thing they are attempting to do.
2. You Hold Losing Positions too Long
Investors, by and large, tend to hold losing positions too long. Most top financial professionals and top investors seem to sell off losers quickly. Good investors are disciplined and are able to acknowledge losers when new information comes in.
I've experienced this desire to hold on to a losing stock in my own portfolio. I invested in a stock in an emerging market. My reasoning for investing in the stock was sound and many top financial professionals recommended purchasing equities in that specific market and of that specific firm. Two years later the position not only didn't move anywhere, but it had declined more than 10%. Things changed in the global economy - the country was doing poorly and exchange rates negatively impacted my investment. I didn't want to acknowledge the fact that I had chosen a loser because I bought the stock with a lot of conviction and spoke about my belief in the stock's future performance to others. However, I was disciplined enough to sell and free up the capital. I knew that the situation wasn't going to get better - it wasn't a momentary downturn in an otherwise great situation but was instead a structurally poor situation. the new information that had come in since I first entered into the position indicated that a prudent investor would exist and so I exited. It wasn't easy, but I'm glad I did it for two reasons. First, it freed up useful capital for investment into other stock. Second, it strengthed the "disciplined investor" muscle withing me by going against myself and forcing myself to do the prudent thing. I believe it will be easier (slightly easier) the next time a situation like this happens.
Why do investors tend to hold losing positions too long? That's a tough question to answer, but behavioral finance has attempted to answer it in recent years. It seems that investors only care about realized losses, not potential. Realized losses occur when you actually sell the position. When I sold my losing stock in the example above, the loss became realized. Investors generally seem to be fine with unrealized (or potential) losses because they are able to imagine the stock going back up. By selling the stock, they realize the loss and lose the opportunity for a price recovery. However, this is not a rational approach. Investments shouldn't be held because you can't stomach locking in your loss. Investments should be kept because they are still good investments and they are investments you would make today. whenever you're facing such a situation, ask yourself the following illuminating question: If I didn't own this stock (or any other type of investment), would I buy it today? If the answer is no, that's a good indication that you should sell it.
3. You Sell Winning Positions too Quickly
Investors typically hold on to losers too long, but they don't hold on to winners long enough. The average retail investor sells winners too quickly in an attempt to lock in the gains. It is possible that the same realized vs. unrealized phenomenon is at play here - investors prefer realized gains to unrealized gains. The problem is that selling to realize gains isn't a good reason to sell. Just as we discussed above, you should only sell a stock you own when it is no longer a good investment. You can ask yourself the same question we asked above: If I didn't own this stock, would I purchase it? If you would, then you shouldn't sell just because you made money with it. If you believe it's still a good investment and that it will rise in value, you should stay invested in it and you shouldn't sell it.
4. You're too Greedy
Greedy investors don't do well over the long term. Greedy investors buy and sell too often (Reason 1 above) and they often sell too quickly (Reason 3 above). Additionally, greedy investors get in at the wrong time and get out at the wrong time.
I'm sure you've heard of the popular investment saying: Buy low and sell high. Well, greedy investors often buy HIGH and sell LOW. They don't do it consciously, but they do it because they are unaware of what is driving their desire to enter or exit the markets. Greedy investors look at the market after a nice long bull run and ask themselves why they didn't get in earlier. Instead of rationally analyzing the current situation, they get in. Greedy investors take stock tips from people or get into speculative investments that have big upside potential but also a very big downside potential and where the chances of success aren't great. Great investors, however, try to find investments with big upsides but very little downsides (or no downsides at all - yes that might be possible).
When greed drives your actions there is little room for prudence and rationality to enter into the equation. You should attempt to keep calm in both bull markets and bear markets and do your best to objectively look at the situation. Additionally, it is important for you to keep in mind that quick money is very rare for the average investor because there are thousands of highly-trained, highly-educated, and highly-incentivized people in finance attempting to beat the markets. Do you think you can outdo them sitting at your computer at home or in your office? The answer is mostly likely "no" because you don't have a competitive advantage in this space. Instead, it is better to use your time and energy to play wherever you do have some sort of advantage. The desire for excellent returns and wealth is healthy, but greed is a destructive force both to your being and to your portfolio.
5. You're too Fearful
In the same vain as greed, fear also can be destructive to your portfolio. Fear can cause you to buy and sell too much (Reason 1 above). We said above that investors typically don't sell soon enough when they have poor-performing investments, but there are occasions where investors actually sell losing stocks too soon: panics.
During times of panic such as the Great Depression or the Great Recession (and even during less severe panics such as sharp market downturns and corrections), average investors seem to get scared and exit. This usually is a very bad idea, especially if you're diversified well. If you are diversified well and the entire stock market declined due to a major recession, everything is going to be down (correlations between asset returns usually go to one in times of panic). If everything is going down, that might mean that the situation isn't totally rational. There are some goods stocks and some bad stocks in almost every market - everything going down usually means that there's an irrational drop going on because of fear. If you sell, you're locking in the losses - something investors usually don't like to do but seem to do too often during great crises. A better strategy would be to hold it out and wait for a recovery. In addition to waiting for a recovery, great investors relish downturns and panics because they are able to buy more stocks at discounts - they buy the good companies that are down not because of the companies themselves but because everything is down due to a crisis.
You Can Become a Better Investor
What we can learn from the five reasons above is that most people and most investors:
Further Reading: Are you investing or speculating? - Find out now!