In his famous book, A Random Walk Down Wall Street, Burton Malkiel said, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” In 2012, Research Affiliates of Newport Beach, CA, actually tested this theory and found that the monkeys beat the index by an average of 1.7% for every year since 1964. How, then, can any investor hope to figure out how to sensibly choose an investment strategy?

The reason that a random approach to picking stocks was more successful than a deliberate one was that monkeys don’t care about market capitalization. Its darts were not aimed at or hitting only the largest companies. They also hit smaller companies whose share prices experienced higher growth over time than many of the larger ones.

A well-balanced portfolio may allocate a portion of the total investment to each of the above asset classes in different proportions. In general, we expect greater returns for stocks over bonds, small companies over large companies, and value companies over growth companies. The challenge for your investment advisor is to use this knowledge to optimize your investments.

After experiencing the highs and lows of the Investor Psychology Cycle, people tend to become frustrated and tired of speculation. The silver lining is that they’ve reached an excellent mental state to learn about real investing. Simply stated, the most effective way to escape (or avoid) the Investor’s Dilemma is to become an informed investor. If you have a basic understanding of what you’re doing, why you’re doing it, what the costs are, and what to expect, you’ll feel a greater sense of comfort and confidence. Without that confidence, you’ll likely be driven to make changes that end up costing money and peace of mind. With knowledge, guidance, and an informed investment strategy, you’ll improve your chances of meeting or exceeding your retirement goals.

To build a retirement portfolio that protects and grows your savings so you can use your hard-earned money in your golden years, you will need to develop, with the guidance of your investment professional, a plan that considers your unique issues, and stick to it.

Inflation eats away at money languishing in a bank or under a mattress. The fear of making a mistake rightly makes us pause before sinking our savings into an investment vehicle.

But we are emotional beings, and often need to make important decisions based on limited information. Since this will never change, errors are inevitable; they should be acknowledged, learned from, and planned for. As George Soros, a highly successful investor, correctly observed, “Once we realize that imperfect understanding is the human condition, there is no shame in being wrong, only failing to correct our mistakes.”

Being very specific and clear about your goals when creating your financial plan is an effective way to minimize errors. A well organized, comprehensive and specific financial plan will help avoid the temptation to cash out when you hear colleagues taking about taking expensive vacations, buying a new car, etc. It also helps to remember what you’re risking before you decide to shift into more volatile investments. Being honest with yourself and a trusted advisor at the planning stage will give you greater confidence in your plan, confidence that, in turn, will spare you from many sleepless nights and premature gray hair.

Here is some sage wisdom that I have found particularly helpful:

• Have realistic expectations about the future.
• Let go of outcomes we can’t control.
• Do second-guess; trust your plan.
• Don’t measure yourself against others.

The chart below illustrates the emotional roller coaster underlying the Investor’s Dilemma. You will probably recognize some of the emotions. If an investor’s account balance increases, he tends to feel happy, while if the account balance decreases, he will be unhappy and may lose confidence in his investment strategy. When an investor lacks confidence, he may be driven to sell (inevitably at a low price because of all the other investors just like him who are acting on emotion) and make other unwise changes to his portfolio. Most investors don’t realize when they’re caught in this cycle.

Similarly, when a fund manager’s predictions about the market prove incorrect, he may lose confidence in his decisions and make unnecessary changes in his clients’ portfolios. Although these changes may be motivated by a desire to protect the investor, making hasty changes breaks one of the key rules of sound investing, and almost invariably results in lower returns.

The desire to limit losses is a perfectly reasonable, but it brings the investor back to the beginning of the cycle, which begins with fear. If that fear had led an investor to cash out early in 2009, he would have missed the mid-2009 rally. That’s why Buy and Hold is one of the key rules of investing.

Transaction costs are fees or commissions charged by the broker whenever he buys or sells an investment. Reacting emotionally and deciding to sell when you hear bad news about a company, or buying every time someone hints that something big is going to happen is bad for your portfolio (even as it’s good for your broker’s wallets).

In addition to the potential opportunity cost of buying or selling a stock, every trade you make triggers a fee or commission. For that reason, brokers have little incentive to discourage your trading decisions.

This holds true for fund managers as well as individual investors. In the case of a mutual fund, the fund pays commissions, and possibly other fees, that are deducted from your portfolio. (There’s even a form of fraud called “churning,” which is when brokers execute pointless or unnecessary trades to generate more commissions. That’s why it’s important to understand how your investment professional is compensated.

There are over 10,000 publicly traded stocks and 30,000 mutual funds. How can anyone possibly know which are good or bad investments? How can you determine what factors will positively or negatively affect those investments?

We are constantly bombarded with information, performance statistics, and marketing messages about investment options. Every firm tries to convince us that they are the best but their products are virtually indistinguishable from those of their competitors. In the face of so much information and distractions, people understandably resort to making investment decisions based on emotion rather than logic.

Whenever emotions drive decisions, we make bad choices. Individual investors tend to act hastily, selling a stock whose price is falling, or buying one from a company that someone says is “hot.” Even experienced fund managers act on emotion, trading stocks in their portfolios far more often than necessary.

One way mutual fund managers achieve a four to five-star Morningstar rating is by taking advantage of the Law of Large Numbers. A manager who actively or passively manages a large number of mutual funds has a very high chance of obtaining one or more funds that outperform the stock market across the two-, three-, or five-year period that is used to determine a mutual fund’s rating. If you only have one mutual fund, then the chance that that fund will outperform the market for five years in a row is very small. However, if you have 100 mutual funds, the chance that at least one will outperform the market is higher. All a mutual fund manager needs to do is create enough funds to increase the statistical likelihood that at least one will beat the market for five straight years, and then aggressively publicize that fund’s performance. By dissolving the unsuccessful funds and pointing to the successful fund(s), a fund manager can profit handsomely from pretending to know what the future holds.

Probability is the analysis of random phenomena that teaches us it is not possible to predict the outcome of discrete events, such as the chance that a stock will either increase or decrease in price.

According to the law of probability, a fund has a 50% chance of increasing in any year and a 50% chance of decreasing over the same time period. The fact that it increases one year does not change the fact that the following year it still has a 50:50 chance of increasing or decreasing.

That’s why it is inappropriate to rely on past performance when evaluating a mutual fund for investment. Brokerages may have hundreds or thousands of mutual funds that contain different mixes of the asset classes. By random chance, some will do well while others will not. What these funds advertise, but don’t explain, is that one of their funds achieved the “past performance” results that they promote. They don’t mention that all its other funds fell short of that level of performance. When you’re looking at past performance, remember that you’re only seeing part of the picture.

This is like misinterpreting the sign posted in casinos that reads something like, “We Pay Back 92% of Your Money!” (The exclamation mark is intended to make you believe that this is a good thing.) And 92% out of 100 is good – until you realize that it means that, on average, the best a gambler can hope to do is lose only 8% of his money. (Some people will win more than this average and some people will lose more.) Expecting a fund to achieve the same performance as it did the previous year is just gambling with your investment.

Mutual funds, retail brokers and financial advisors aggressively market funds awarded four and five stars by Morningstar, the Chicago-based arbiter of investment performance. But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. The search for top-performing stock funds is an exercise that will come to be viewed as one of the great financial follies of the late 20th century.

Here’s an example of performance-based marketing. In the November 2000 issue of Money magazine, there was an ad headlined: “Tech stocks still hot. It touted a number one ranking and five stars. In 1998, the fund returned 196%, and 216% in 1999! Pretty impressive, right? But if you added this fund to your portfolio in 1999 or 2000, you would have noticed that it returned a dismal -51% in 2000. I’m quite sure there were no similar ads for the fund in 2001.

As the chart below illustrates, the reality is that even the top funds rarely exhibit the same performance for even two consecutive years.

From 2002–2012, on average only 7% of the top 100 fund managers repeated their performance the following year. In the years 2008 and 2009, no fund managers repeated their previous year’s top 100 performance.

A Wall Street Journal and Morningstar study found that 72% of consumers invested their money in four- and five-star-rated mutual funds that showed the highest returns during the previous three–five years. Funds focus on “past performance” for one simple reason: because it works in attracting new investment.

Investors typically fear not having enough money to live comfortably when they retire, or becoming a burden to family and friends in their old age. They also have a fear of investing poorly, a fear of missing out on a golden opportunity, and a fear of not being able to interpret complex information. While fear drives many hasty decisions, it is not the only dangerous emotion. Excitement also leads people to make hasty decisions. People get excited about the prospect of getting rich, imagining they are getting in on the “ground floor” of the next big investment boom.

The investment industry exploits these emotions in its advertising, using past fund performance to attract investment in their fund. By implying that they can predict the market’s future, investment firms prey on investors’ emotions.

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

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.