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Recently we started a 3 Part Series about the most important factors for portfolio performance. They were:
  1. Staying passively diversified vs. actively trying to beat the market
  2. Keeping costs as low as possible vs. following good past performance funds
  3. Removing emotions from investing vs. following the fear and greed cycle
Research shows that following these three simple principles long-term can add between 6% and 8% annually to your portfolio’s performance.

Today, we will discuss principle number three.

Emotions –they try to sneak inside all types of places, and yes they made it inside your portfolio and inside your mind trying to affect how you think, react and ‘feel’ about money. They are so powerful; the economists even had to develop an entire field of economics to ‘understand’ them, called Behavioral Economics. It’s the field that tries to make sense of why we do certain things (towards money) that we wouldn’t do in other fields.



Running towards the mall at the 50% Off sale sign, but running away from the stock market at the same 50% Off sale sign. (Notice their faces too)

The study of Behavioral Economics tries to understand how two basic instincts/emotions, Greed and Fear, guide most of investors’ financial and investment management process.
Here are a few questions to ask ourselves to find out if we’re prone to such powerful emotions when we think about money and investing:

  1. How often do you purchase a ‘very good’ investment, just to see it decline (sometimes by a lot) shortly after?
  2. How often do you sell (angrily at times) an investment because it has done poorly, just to see it increase (significantly at times) after you sell?
  3. How often do you stay on the sidelines (cash) waiting for the ‘right’ price to buy or sell?
  4. How often do we buy an investment just because it has a good past performance record? If Yes, how often do you drive by only looking in the rearview mirror?
  5. Lastly, how often do you feel that all of this doesn’t make any sense - all is not right with the investing world and markets don’t work, especially for the ‘little guy’?
Pretty much, all of us at one point or another (if we’ve done some investing) will tend to agree and answer YES, to the questions above (except the driving one - tricky at best). We often then conclude to completely avoid investing, rationalizing as ‘not for me’, too risky, ‘crooked markets’, ‘Wall Street, this or that’ etc.

While the stock markets have been volatile (to say the least) in the last few years, passing through the great recession in 2008-2009, and climbing through the ‘wall of worry’ after that, markets are doing exactly what they do and what they’ve done since the beginning of the stock market – they go up and then they go down. But the stock market is just doing what it does – and still, counting all the ups and downs after all, the S&P 500 index (as representative of US stock market) has returned on average over 10% annually in the last 30 years as well as over the last 90 years. Coincidence or just what the markets do?

The question is, though, how many investors have actually achieved that performance, and the answer is ‘very few’. This is primarily because of their own biases, emotions, timing the market, and maybe even due to high (but unknown) fees. There’s actually long term data on this, that shows that while the US stock market (S&P 500) averaged 11.06% annual from 1985-2014, the average investor (in stock funds) averaged just 3.79% annual, for a ‘gap’ of over 7% annual. This data is taken from Dalbar, Inc., a company that’s been collectively tracking the individual investor’s performance for the last 30 years.

A known advisor, Carl Richards, author of The Behavior Gap, even coined the term ‘Behavior Gap’ describing the gap (lost performance) due to our own emotions in investing. He’s well known for his overly-simplistic sketches that need no interpretation. I’ll leave you with the best two sketches, in my mind. Let them sink in.

Sincerely,

Lead Advisor, InvestEd.

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