A successful investment strategy requires understanding more than the technical factors involved in growing your investment. It also requires understanding the very real role that emotion plays – not only on an investor but even on an investment professional.
For example, a rational person knows that inflation (and, in recent history, abnormally low interest rates) makes putting money into a savings account with 0.1% interest, or hiding it under your mattresses, a poor strategy for maintaining or growing purchasing power. But the overwhelming amount of information investors confront causes great uncertainty, much like the feeling of being a rat lost in a maze. Understanding a little about investor psychology will help you navigate that maze and enjoy the satisfying taste of the cheese when you reach your goal.
Dalbar QAIB (1984-2013) Results Summary
|
Category |
1984-2013 Annualized Return |
|
S&P 500 Index |
11.10% |
|
Average Investor |
3.69% |
|
Inflation |
2.80% |
According to Dalbar, Inc., a firm that studies investor behavior, between 1984 and 2013, the S&P 500 index earned, on average, 11.10% each year. Over the same period, the average investor earned an average of only 3.69% each year. That is only 0.89% above the rate of inflation, and far short of the S&P 500’s performance by a staggering of 7.41%! How is that possible?
While someone who invested $10,000 in the S&P 500 in 1984 could have earned $225,000 during that same period, that person left, on average, 67% of the potential gain ($150,750) on the table. That money went, instead, to the brokerage firms through commissions and fees.
According to Dalbar President Lou Harvey, individual investors typically mistime their trading decisions: they do the wrong thing at the wrong time, even though their money depends on them getting in and out of an investment at the right time. Such poor timing can often be traced to a counter-productive cycle known as the “Investor’s Dilemma” that many people go through when making investment decisions. This involves making decisions based on emotions rather than on facts. Understanding and recognizing this cycle is the best way to ensure that you avoid it altogether.