Why Investors Lag the Market

Savers often make emotional investment decisions or follow illogical advice.

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Various reports have come out over the years showing that, on average, investors experience lower returns than the stock market averages.

One study by the firm Dalbar covered the 20-year period from 1988 to 2007. During this time, the S&P offered average annual returns of 11.8 percent. But the average mutual fund investor earned only 4.5 percent annually. A report on ETFs reached a similar conclusion. In 68 out of 79 ETFs, the returns experienced by investors lagged that of the ETFs themselves by over 4 percent.

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A Dalbar update for 2010 concluded that, “the psychological factors that batter away at the average investor still exist.” But how can the average investor do worse than average? Here are three common psychological barriers to sound investing.

1. We trip over ourselves to rush into stocks when the market is going up, and panic and rush out just as prices are bottoming. Or, as analysts concluded by examining actual fund flows, “Investors often buy and sell at the worst possible times.” Let’s face it, the herding instinct is strong. It takes a lot of confidence to buy when we see everyone else is selling or sell when all our friends are talking about the killing they made on an Internet or gold stock.

You’ve heard the old axiom that the trend is your friend, and so you want to jump on the trend. The problem is, trends are easy to spot when they’ve been going on for a while, but they’re hard to identify early in the process. And usually by the time you spot a trend it’s already past its prime.

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2. We stumble into something we know nothing about. Unless you can read income statements and balance sheets and have a pretty good insight into a company and an industry, you have no business buying an individual stock. There are too many variables beyond your sphere of knowledge that could impact the company. What if there is a new product from a competitor, an accounting scandal, or a failed acquisition?

The same goes for commodities or any specialized ETF you might think represents the wave of the future, even though you know nothing about the underlying business. I remember when alternative energy ETFs were hot a couple of years ago, when Barack Obama was going to get elected and usher in a new world of clean energy. Most of those ETFs are now worth less than half of what they were in 2008.

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3. We fall for the latest fad or the next big thing promoted on CNBC or a tip from a friend or relative. My brother-in-law likes to talk investments down at the bar. He has a good time, buys lots of drinks, and eats some good food. Out of all the tips he gets, one or two actually do pan out. But most of the time he loses money. He bought investment real estate in 2006 in Florida. That’s why I have my not-so-tongue-in-cheek rule of thumb: Do the opposite of what your brother-in-law is doing.

There are always a few people who beat the market. They exploit their special knowledge about a particular industry, possess uncanny mathematical skills, or just have good luck. But for most people, the best way to invest is the old way: Dollar-cost average your money into a broad-based index mutual fund like the Vanguard Total Stock Market Index Fund (VTSMX) or the Fidelity Spartan 500 Index Fund (FUSEX) or an ETF like the SPDR S&P 500 Fund (SPY) or the SPDR Dow Jones Fund (DIA). I know it’s boring, but you need to look at the stock market as a way to increase your savings, not provide you with entertainment.

Tom Sightings is a former publishing executive who was eased into early retirement in his mid-50s. He lives in the New York area and blogs at Sightings at 60, where he covers health, finance, retirement, and other concerns of baby boomers who realize that somehow they have grown up.