How to Become a Better Investor
Image: George Catlin, Cabane's Trading House, 930 Miles above St. Louis (1832)
The sooner you realize you suck at investing, the sooner you’ll become a successful investor. Unfortunately, many people believe they are the exception. The truth is, most people barely achieve ⅓ of broad market returns due to their emotional decisions.
This isn't simply about stock picking or choosing a fund manager who will outperform. It's about swimming against powerful market tides.
You Suck in Bear Markets
Bear markets are a form of psychological torture. Believe me when I tell you that even seasoned investors are tempted to sell everything when markets are pummeled. The relentless and pervasive barrage of negativity goes on for months leading even the most resolute to question their own beliefs.
Whether you invest in stocks, index funds or active funds, do you have the intestinal fortitude to buy when the entire market is dying and everyone is screaming 'sell'? It is easy to say 'yes' from the comfort of your armchair when unemployment sits at record lows and markets are near all-time highs. But it isn't as easy when your friends and family are losing their jobs and people are going bankrupt. At that point in time, self preservation becomes paramount and one can easily rationalize selling underwater investments to protect what's left.
You Suck in Bull Markets
It is just as difficult to do the opposite (sell) when everyone around you is getting rich off the last vapors of a bull rally. The conservative investor that misses the final months (or even years) of a bull market is made to feel stupid. Meanwhile, your friends and family with sub-par IQs are rolling in dough as they plow every penny into risky assets.
These are precisely the emotions you need to combat even if you simply want to passively buy and hold low cost index funds to match market performance. Investing is simple...until it's not. It's simple until you start paying attention to the noise around you. Unfortunately, the noise is hard to ignore.
These emotional decisions cause investors to lock in losses and miss out on gains. Consequently, the average investor vastly under-performed the broad stock market over a 20 year period.
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How Does the Typical Investor Actually Perform?
According to Richard Bernstein of Richard Bernstein Advisors:
"The performance of the typical investor over this time period is shockingly poor. The average investor has under-performed every category except Asian emerging market and Japanese equities. The average investor even under-performed cash (listed here as 3-month t-bills)! The average investor under-performed nearly every asset class. They could have improved performance by simply buying and holding any asset class other than Asian emerging market or Japanese equities. Thus, their under-performance suggests investors' timing of asset allocation decisions must have been particularly poor, i.e., investors consistently bought assets that were overvalued and sold assets that were undervalued."
BlackRock made similar comments back in 2012:
"Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense. Psychological factors such as fear often translate into poor timing of buys and sells. Though portfolio managers expend enormous efforts making investment decisions, investors often give up these extra percentage points in poorly timed decisions. As a result, the average investor under-performed most asset classes over the past 20 years. Investors even under-performed inflation by 0.5%."
How to Become a Better Investor
So what can you do? Perhaps the more appropriate question is 'how can you do less?'. Because it is the 'doing' - the unplanned activity - that causes investors to fall behind.
The best way to avoid unnecessary and detrimental activity is to build a plan for how you want to invest, in good times and bad. Perhaps the simplest plan is to invest a percentage of your paycheck every month into a pre-selected set of investments that align with your risk tolerance and objectives. Your plan can be more elaborate if you choose - e.g. creating trading rules such as stop losses - but for most the simple approach is best because it doesn't require expert knowledge and is easy to execute.
Most importantly, make the decision today about how you plan to behave when markets are plummeting or irrationally exuberant. Because when you're in the heat of a bear market or bubble economy, emotions will take over and you won't be able to make rational decisions.