The Psychology of Investing

One of my favorite quotes concerning investor behavior comes from the original guru of value investing, Mr. Benjamin Graham.  His quote; “The investor’s chief problem and even worst enemy is likely to be himself.”  In my opinion this quote points to one the biggest reasons why individual investors fail to outperform the markets (other reasons are high fees, poor funds and lack of diversification).  In fact, a study done by Dalbar, Inc. found that from the period of 1987 to 2007 the average investor underperformed the market index (i.e. S&P 500) by an average 7.3% per year!  This is an amazing difference of returns!  How can individuals produce such low returns compared to the market index?

Investor Behavior Causes Poor Market Returns

Several studies about investor behavior show that when the stock market goes up, people pour money into equity mutual funds, and when the market goes down, they pull money out. During bear markets, they pull even more money out. Therefore, they continuously chase trends (buy high and sell low) focusing on what is happening right now, not what will happen in the future.

Let’s face it, our emotions are our biggest enemy when it comes to successful investing.  This destructive behavior is what I like to call, “the greed vs. fear battle”.    When fear takes hold, it impinges our ability to make informed decisions.  That is, we tend to want to reevaluate our risk tolerance when the market is going down for “fear” of losing money. This behavior causes us to sell or change our investments at or near the market bottom.  Conversely, when the markets are going higher, we want to start investing again so we do not miss the big rally.  This “greedy” behavior generally backfires, as we will enter the market at or near the highs. Both irrational behaviors cause individual performance returns to be substantially less than index stock market returns.

Four Ways to Increase Your Market Returns

When it comes to your investments, if you feel your emotions are getting the best of you, come back to the following rules:

1. Do nothing  -   A conscious decision to do nothing is still a form of action.
2. Your money is like soap  -   To quote Gene Fama Jr., a famed economist, “Your money is like soap. The more you handle it, the less you’ll have.”
3. Never sell equities in a down market  -  If your funds are allocated correctly you should never have a need to sell equities during a down market cycle. This holds true even if you are taking income. Just as you wouldn’t run out and put a for sale sign on your home when the housing market turns south, don’t be rash to sell equities when the stock market goes through a bear cycle.  Wait it out.
4. Science works  -  It’s been academically proven that a disciplined approach to investing delivers higher market returns. Yeah, it’s boring; but it works.

Start following these truths now and become one of the few investors earning above average market returns!

(CWM does not make any representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information prepared by David Damm and takes no responsibility therefore. All such information is provided solely for convenience purposes only and all readers thereof should be guided accordingly.)