What most Individual Investors do Wrong?08-12-2010 |
What most Individual Investors do Wrong?
Nationally recognized research firm Dalbar recently produced the results of a study on the overall performance effects of individual investor behavior. In doing so, they compared the returns of the stock market (as defined by the S&P 500 index for these purposes) and the returns of the average individual investor in equities over a 20 year period that started on December 31, 1989 and ended on December 31, 2009. Interestingly, the study showed that the average return of the S&P 500 over that period was 8.20% while the average return of the individual investor was just 3.17% over the same time period. This represents a relatively stark 5%+ difference.
While we, at Hennion & Walsh, are not suggesting that a “set it and forget it” strategy of investing in the U.S. Large Cap stocks comprised by the S&P 500 is a prudent path for individual investors to follow going forward, we do believe that this empirical data highlights what most individual investors do wrong with respect to their investment portfolios. For the benefit of all individual investors reading this post, below we list the 10 things that most individual investors do wrong in our opinion:
- Investors let their emotions get in the way of sound investment decisions
Investors are driven by fear and euphoria into making purchase and sale decisions that often run contra to their long-term investment plan. Buying high and selling low is never a good recipe for portfolio performance. The media plays into these human emotions and while it is important to obtain knowledge about the economy and the markets from the media, it is also important to have an appropriate filter for the information before taking any actions based upon the information.
- Investors try to time the market
As the landmark “Determinants of Portfolio Performance” study conducted in 1991 by Brinson, Singer and Beebower concluded, it is asset allocation that accounts for more than 91% of portfolio performance – many times greater than the selection and timing of individual security transactions. We believe that trying to time the market is often an exercise in futility for most individual investors.
- Investors do not have buy and sell disciplines
Most individual investors can provide a long dissertation as to why they purchased a given security in their portfolio. However, ask those same individual investors what causes them to sell a given security and they do not have an answer. Further, many individual investors tend to hold onto securities in their portfolio solely due to a concern over having to pay taxes on the capital gains of the holdings. Having a concrete sell discipline in place is equally as important as having sound purchase criteria in place.
- Investors chase returns
As opposed to building a diversified portfolio suitable to their own financial situation, individual investors tend to try and chase returns. Investors should remember that yesterday’s stars are not necessarily tomorrow’s winners and past performance is not an indication of future results.
- Investors are not honest with themselves about their true tolerance for risk
We have observed that individual investors tend to increase their risk tolerance in bull markets and decrease their risk tolerance in bear markets. When this occurs, investors generally tend to fall short of their performance expectations because statistics show that individual investors are not successful in timing the market consistently. An investor’s true tolerance for risk should not change based upon the direction of the market.
- Investors do not have a personalized investment strategy in place
Simply saying that they “want to make money” or “growth their wealth” is not an investment goal for an individual investor. Investors should consult an experienced money manager to develop an investment plan specific to each investor’s own financial resources, tax bracket, income needs, growth objectives, investment timeframe and risk tolerance. It is then the responsibility of the individual investor to remain committed to the investment plan that is developed and agreed upon.
- Investors too often try to find the “Needle in the Haystack”
While certain asset classes and sectors warrant the utilization of active investment strategies that try to find the most profitable “needles in the haystack”, we feel that other, more efficient asset classes or sectors would be more appropriate for passive investment strategies that simply invest in the “haystack” itself. These passive strategies can be found through index tracking mutual funds and Exchange-traded products (ETPs) such as Exchange-traded funds (ETFs) and Exchange-traded notes (ETNs).
- Investors do not consider a wide enough array of asset classes and sectors for their portfolios
Far too often, when we meet with prospective clients, we hear that they believe that they have a diversified portfolio of stocks. Upon further investigation, we determine that these investors generally have a portfolio of stocks largely weighted towards the U.S. Large Cap asset class (i.e. the “Blue Chips”). Having a portfolio of predominantly U.S. large cap stocks may present unnecessary concentration risk to the growth portion of an investor portfolio following a decade where the DJIA lost 9.3% in the 2000’s – the second worst decade performance in history.
Investors should consider adding a wider range of asset classes including available alternative and hybrid investment strategies, as we have, to their portfolios given the uncertainty in the markets in the months ahead. Remember that stocks are not the only investment strategy that can provide growth opportunities to a portfolio.
- Investors do not revisit and/or rebalance their investment strategies often enough
Once an investment plan has been implemented, investors need to revisit these plans, at least annually, to ensure that:
- The asset allocations have not strayed too far from their target weightings. Rebalancing can be a difficult concept for most investors to appreciate as it generally involves selling a portion of a portfolio’s winners and buying more of a portfolio’s losers.
- The asset allocation weightings are still relevant for the current markets.
- Their lifestyles have not changed so significantly that the changes would necessitate a change to their overall investment plan (Ex. early retirement).
- Investors believe that they can navigate the capital markets on their own and do not consult an experienced money manager
Consulting a professional money manager should not be deemed as an admission of failure or a sign of weakness to an individual investor. Rather, it should be perceived as a sign of strength and evidence of wisdom that the “Coach” of a household portfolio has retained the services of an all-star player to help his team (i.e. household) achieve financial success.