The #1 Reason the Average Investor Has Not Accomplished His Financial Goals Yet
Stop buying high and selling low
“Investing is not nearly as difficult as it looks. Successful investing involves doing a few things right and avoiding serious mistakes.” — John Bogle
We often ear a lot of debates about what the next hot thing will be.
What is it this time? Cryptos? Tech? Private equity? Gold?
Yet, for the average investor, the truth is it doesn’t matter.
For most of us, investing is not about finding the next Amazon, it’s about building an investment strategy that will help us reach our life plans in the long run.
“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” — Paul Samuelson
Years of research shows that the only way to achieve your financial goals is to define a long-term diversified strategy and stick to it.
Yet most people underestimate the impact of their emotional biases on their financial well-being.
What are your financial goals?
What are your life plans? Why haven’t you achieved them yet? What is your investment strategy?
The Average Investor Underperforms the Market (Any Market)
“Most Investors Turn a Winner’s Game into a Loser’s Game.” — John C. Bogle
According to data from J.P. Morgan Asset Management, the average investor has made 2.6% per year for the last 20 years. Less than any asset class over the same period:
It’s embarrassing.
If you had invested your money in any asset class over the same period, you would have been better off.
Also note that in real term, the average investor has made a tiny 0.5% per year.
If you live in Europe, the numbers are even worse.
To put things in perspective, consider the returns earned on $10,000 over 20 years. Let’s compare “Mr. Average” and “Mr. Market” (symbolized by the S&P 500):
The simple investment in the stock market grows to $40,169, a remarkable illustration of the magic of compounding returns over a 20-year investment period.
But the average investor gave up nearly 78% of this potential accumulation.
By the end of the period, his investment totals just $16,709, a shortfall of $23,460 to the cumulative return earned in the market.
This is a huge gap.
Anyone looking at this chart is tempted to ask: why are we so bad?
In fact, I’ve always been interested in understanding the reasons behind this gap.
If you are familiar with investing, you’ll be tempted to answer that this is because of the cumulative cost of fees.
While cost reduction is definitely something to look for, there is something more.
The problem with your investment is not the product, it’s the process.
The key factor preventing savers from achieving their investment goals is the inappropriateness of the initial investment strategy for their risk tolerance.
Defining Your Risk Tolerance
“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.” –Jason Zweig
Risk tolerance is a function of a person’s ability to bear risk (fluctuations in the value of their investments) and attitude towards risk, a behavioral aspect that can be described as a willingness to take risks.
Risk profiling is a holistic process that can be outlined like this:
As a CFA candidate, I’ve learned that the framework to determine risk tolerance is twofold (as shown above).
As an investment professional, I’ve learned that in practice, we often neglect the behavioral aspect.
Why?
Simple: traditional advisors and private banks fail to do it properly because the advisor is biased by his own risk aversion.
The conventional approach consists in doing the minimum regulatory requirement before selling an investment product to a client.
This is not convincing.
The robo-advisors haven’t found a practical way to automate its assessment yet.
Someday, we will probably be able to draw a complete behavioral chart of someone by combining AI and Big Data. For now, we don’t know how to test the willingness to take risk efficiently.
And the DIY community is often subject to its own bias. In short, we picture ourselves smarter than we are, and we underestimate our ability to panic.
The consequence?
The result is significant under-performance because of emotional reactions of investors who put an end to their investment or shift their strategy at the worst time possible.
Buying High and Selling Low
“Buy low and sell high. It’s pretty simple. The problem is knowing what’s low and what’s high.” — Jim Rogers
Let’s see what happens in practice for the average investor.
The chart below summarizes Equity Mutual Funds flows over the period 1997–2013:
The average investor has never poured more money in the equity market than during the year 2000, at the bull market peak.
The bursting of the .com bubble followed immediately.
what’s more?
In 2009, after one of the greatest bear market in history, Mr. Average pulled his saving (or at least what was left) out of the stock market.
He did not enjoy the rebound that followed the great financial crisis.
See, Mr. Average is doing the exact opposite of the #1 common sense rule of investing.
He is buying high and selling low.
This behavior is devastating to the return experienced by the average investor.
This is human nature. When things go south, we tend to let our emotions influence our investment decisions.
It makes no sense.
There is no rationale to alter your long-term strategy in response to short-term movements (however extreme) in the stock market.
Yet, this is precisely what happens.
In Conclusion
“The investor’s chief problem — even his worst enemy — is likely to be himself.” — Benjamin Graham
The #1 reason the average investor has not accomplished his financial goals Yet?
Emotional biases.
Inadequate risk profiling coupled with a lack of emotional management is to blame for most of the shortfall experienced by the average investor.
Stop overlooking the behavioral aspects of investing, formalize your own attitudes towards money and calibrate your risk level.
Define a strategy that suits your objectives and start growing your net worth.
Once you have defined your strategy, the hard part is sticking to the plan.
Automatize the process and forget it.
The reason you haven’t achieved your financial goals yet has to do with managing your emotions.
“Buy and Hold? Sure, but Don’t Forget the Hold.” — Mark Hulbert
Haven’t reached your #1 financial goal? Your solution is simple:
Design an investment process that removes your emotions from the equation.
