As I write this article, the Dow Jones Industrial Average sits at 13,000 – almost exactly double what it was during the market lows of March 2009. Good news, right? Not if you’re one of the many investors who chose to get out of the market over the last three years.
The graphic below shows the increase the DJIA has made since 2009 contrasted with the monthly liquidation of equity mutual funds during the same period of time.
What is painfully clear is that as the DJIA continued to climb, individual investors were pulling out billions of dollars from the market. In fact, according to the Investment Company Institute, investors in ordinary domestic mutual funds have withdrawn $490 billion from the U.S. Stock Market over the past 5 years. This movement out of the market has had staggering repercussions. In Brett Arends’ February 2012 article, Main Street’s $100 Billion Stock-Market Blunder, he estimates that because investors sold when they should have been buying, they gave up a mind-boggling $106 billion in profits.
Unfortunately, this type of investor behavior is nothing new. Last month, the nation’s leading financial services market research firm, DALBAR, released its eighteenth annual edition of the Quantitative Analysis of Investor Behavior (QAIB). The QAIB looks back at the previous twenty years to evaluate actual investor returns, as well as the behaviors that produce those returns. In the chart below, we see how the average investor stacks up against relevant benchmarks.
During the 20-year period ending on December 31, 2011, the average equity investor underperformed the S&P 500 by 4.32% on an annualized basis. The average fixed income investor fared even worse, staggering behind Barclay’s Aggregate Bond Index by 5.56% on an annualized basis. The one-year returns for 2011 are even more disheartening. Last year, the average equity investor trailed behind the S&P 500 by 7.85%.
To have long-term success as an investor, you must understand the gap between the returns of the average investor and those of the indices has nothing to do with the market – and everything to do with you. To be very clear, the problem isn’t that you choose the wrong investments – it’s that you can’t stick with them. DALBAR calls it, “investor irrationality.” Yet as troublesome as it is, irrational behavior is part of the human condition.
We all know the Stock Market goes up over the long run. However, few investors stick with a strategy long enough to derive any long-term benefits. So how do you avoid making the costly mistake of letting your emotions push you out of the market at the wrong time?
The first step is to choose your investments wisely. You should choose investments based on your time horizon, risk tolerance, and long-term financial objectives. The second step is to stay the course. In other words, never sell an investment just because it is down in price. Assuming you chose your investments appropriately in the first place, the only reason to sell is if you can do so at a profit, or your time horizon, risk tolerance, or financial objective has changed. The chance of having a significant shift in any of those is slim and furthermore, should have nothing to do with economic, geopolitical, or market events.
As an investor, there are a lot of things you can’t control, including the business cycle, stock prices, and inflation, just to name of a few. But at the top of the list of the things that you can and should control is your emotions. Because, in the words of Nick Murray, “… the dominant determinant of real-life, long-term investment outcomes is not investment performance; it is investment behavior. “
Free Special Report – The Four Most Dangerous Words in Investing