Studies of investor behavior show that the average stock mutual fund returned 9.9% annualized in the two decades from 1991 to 2010. But the average fund owner only earned 3.8% on average per year.
How is this possible?
There is a big gap between market returns and what an investor earns. A number of studies have demonstrated that the biggest reason is investor psychology. The average investor operating on his own behaves in highly predictable ways, consistently buying when prices are high and selling when they are low. This has very little to do with intelligence or wisdom. Emotions affect us all.
No matter how astute an investor might be, a drop in excess of a certain percent causes investors to panic and exit the market. The amount of the drop varies with the individual, but the result is that it causes investors to sell at or close to the lows. The same analysis shows that the bulk of investor buying happens after a significant rally and this is frequently close to a near-term market top.
The cycle is often repeated. When the market takes another dip the investor sells again near the bottom, buys back in near the top. Rinse and repeat.
As if to illustrate this, the Wall Street Journal just reported that “Investors Pulled Record $25 Billion From U.S. Stock ETFs in January.” By giving in to their fears following December’s market decline, these sellers sold as the market had one of its best Januaries on record. They locked in their losses and missed the recovery.
Given the human tendency to act in an emotional manner when it comes to investment decisions, it is critically important that properly risk-managed portfolios be designed for investors so that maximum losses are well under their fear threshold. This will let the investor stay in the markets and benefit from long term investment returns.
This is where a risk-managed portfolio, created by a good financial advisor can keep investors from panicking and hurting their performance. A risk-managed portfolio will keep losses under the threshold that causes investors to allow fear to overcome their judgment. In years when the market rises sharply, a risk-managed portfolio will underperform the market because it’s defensive by nature. But it makes up for this underperformance in years when the market drops sharply.
The difference between having a financial advisor and taking your best guess on your own can mean the difference between taking advantage of every opportunity and potentially leaving money on the table.
If you find yourself buying when the market’s already gone up and selling when the market’s near the bottom, call us for a free consultation. We may be able to help.
Arie J. Korving, a CERTIFIED FINANCIAL PLANNER™ professional, has been delivering customized wealth management solutions to his clients for more than three decades. Prior to co-founding Korving & Company, he was First Vice President with UBS Wealth Management and held management positions with General Electric.