There are three main reasons why investors consistently under-perform the investment indices:
- bad investor behaviour
- high investment costs, and
- high investment Portfolio Turnover Ratios (PTRs)
Of the three reasons listed above, No. 1 (bad investor behaviour) is the biggy – accounting for over half of all lost investment returns.
When it comes to our investment decisions, it turns out that our emotions always seem to get the better of us. Specifically, no matter how smart we think we are, we still let our greed and fear dictate our investment choices. When markets rise to new highs, our greed makes us overpay for riskier and riskier investments. And when markets fall, our fear of losing our hard-earned savings makes us sell, and the pain from losing money keeps us on the sidelines longer than we should.
Interestingly, many of us prefer to hand our hard-earned savings over to the professional money managers (the pros) thinking they’ll be better at making investment decisions than we are – free from any of that bothersome greed and fear, right? Not!
Even the pros constantly battle with their emotions when it comes to investing your savings. They don’t worry about losing your money, but they do worry about their careers. Career risk feeds their fear of underperforming their professional peers (i.e. losing that next bonus or promotion, or maybe even their jobs). Plus, their greed is replaced by ego, where they want to outperform their peers and gain status as the next great investing guru. So don’t ever assume that the guys you hand off your savings to are some kind of emotionless robots, because they’re not.
As with any chronic problem, the first step in correcting the problem is to acknowledge the problem exists. Then we can take the necessary steps to ensure the problem is minimized or eliminated.
So if we accept that our emotions make us do dumb things – like buying at the top of markets and selling at the bottom – we can learn to make wiser investment choices that don’t feed those emotions.
Buying an investment at the top of a market cycle can be problematic, but the real dumb behaviour and consequent damage to our savings is done when our fear of losing money feeds our decisions to sell at the bottom of markets. So, when it comes to our bad behaviour, it’s really our fear of losing money that we need to manage better.
An investment’s performance standard deviation is a measure of the investment’s past volatility and it can help you to set realistic expectations for future price changes; those expectations (or warnings of possible ranges) can prevent you from pressing the panic button and going back down the road of bad investment behaviour.
For example, if you buy an investment that has averaged a seven per cent rate of return and it has a performance standard deviation of + and – 20 per cent, then you know the investment’s annual performance was between a gain of 27 per cent and a loss of 13 per cent in 68 per cent of the time (one standard deviation from the average seven per cent). But you also know that in 95 per cent of the time (two standard deviations from the average seven per cent), the investment’s annual performance was somewhere between a gain of 47 per cent and a loss of 33 per cent. Now, that’s a big range (+47 per cent to -33 per cent).
So, making a cool 47 per cent isn’t going to be a problem. But watching your savings drop by 33 per cent, which is the opposite possible extreme as indicated by the investment’s performance standard deviation, would not be fun and might scare youe back into that bad investment behaviour cycle of selling at a bottom market.
So then what?
So, knowing that you are investing emotional weaklings, if you have a better understanding of the potential volatility in the investment’s future performance, then you can better manage your emotions and your investing decisions – which is short for having more fun money in your retirement.
That means that when you’re looking for a new investment, if you think that watching your savings lose 33 per cent in a short time frame might scare you into selling, then maybe you should look for an investment that better suits your emotional limits. Maybe an investment that averages five per cent with a performance standard deviation of + and – 10 per cent is a better fit with your emotions. (Reminder: An investment with this type of performance standard deviation will provide a rate of return somewhere between a gain of 15 per cent and a loss of five per cent in 68 per cent of future years. And in extreme years the investment’s performance might be between a gain of 25 per cent and a loss of 15 per cent in 95 per cent of future years.)
But it’s up to you. You have to know what range of performance you’re most comfortable with. But choosing investments that are a better fit with your emotional limits will help you to minimize your bad investment behaviour (not buying high and not selling low), decrease your investing under-performance, and help you to reach your financial goals a lot sooner.