Common Investor Behaviors That Hurt Investments
In my post from last week, “behavioral coaching” was suggested to have the biggest impact on real-world investor returns. In Vanguard’s analysis, being able to overcome your own behavioral quirks could add more than 1.5% to your returns, as opposed to falling victim to your own human tendencies.
If an advisor can successfully provide behavioral coaching to clients, stopping them from both losing their cool and taking drastic, hasty actions in times of market stress, then the outcome can still be a net win for the client after accounting for fees. Even for those who generally always make the right decision regarding their portfolios, a single investment mistake (such as getting out of the stock market in late 2008/early 2009) made near retirement could overturn years of good decision making.
The impact of making a wrong financial decision as you get older and/or wealthier becomes harder to overcome. Sequence of returns risk has a corollary here: the timing of mistakes can lead some to have a bigger impact on the lifetime standard of living than others.
To further quantify this matter, Financial Engines published a study in May 2014 with Aon Hewitt that looked at outcomes for defined contribution retirement plan participants between 2006 and 2012. The 30.3% of participants who elected to receive some form of help with their retirement plan on average earned 3.32% more per year, net of fees, relative to those not receiving investment help. If you have a $1 million portfolio, that’s over $30,000 you’re leaving on the table.
The study also noted that 60.5% of those not receiving help were taking inappropriate amounts of risk, including a large group of near-retirees holding overall portfolios that were more volatile than the S&P 500.
With behavioral coaching being the biggest factor in improving financial outcomes, further exploration is warranted into the types of behaviors that lead investors astray; this can highlight the importance of having someone serve as a sounding board and provide input when working your way through a lifetime of financial decisions. A short introduction to the topic of behavioral finance would be beneficial at this juncture.
Probably the most damaging behavioral mistake made by real-world investors is succumbing to the greed and fear cycle that causes someone to buy into the market at its peak and sell out at its lows. This natural cycle happens thusly: when markets are doing well, investors get excited and pour more money into the market with the hope that this trend will continue indefinitely. Investors on the sidelines may become jealous of neighbors’ gains and may worry that they are missing out.
But a prolonged run-up generally leads to market valuations becoming misaligned, and it is reasonable to expect a reversal of fortune with lower returns in the future. Nonetheless, popular culture will send repeated messages that this time is somehow different—it is a new economy with a new paradigm, the old rules no longer apply, and so on.
It is tough to rebalance to your strategic asset allocation when markets are rising, because you have to sell shares of the biggest gainers in order to do so. But it is important to have the discipline to stick with your plans and objectives.
A reversal of the market direction is inevitable, causing market prices to plummet. Investors get nervous and some, after seeing significant declines, become scared enough that they start selling off holdings.
Staying the course is an even greater challenge if you are experiencing cognitive decline. Unfortunately, this time in life calls for rebalancing to your strategic asset allocation, which would require buying assets with falling prices rather than selling them. This is a challenge, both emotionally and intellectually.
Naturally, weak markets will eventually recover and go up again. However, the timing of the recovery is unpredictable. You cannot time the market. Instead, you must stick with your financial plan and the asset allocation that matches your tolerance for market volatility.
Unfortunately, investors in financial markets tend to do the opposite of what happens in most other markets: they buy more when prices are high and sell when prices are low. This causes returns to drag dramatically behind what a “buy, hold, and rebalance” investor could have earned.
Staying the course would work better. This is the type of “behavioral coaching” Vanguard refers to in their study.