Why are we such lousy investors? Episode 3: Closing the behavior gap

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Why does the average investor earn returns far below the market return?  In part three of this four-part series, we describe several strategies that investment advisors use to help their clients avoid the pitfalls of poor returns.

Video Script:

Why do most of us earn investment returns far below the market?  Why are we such bad investors?  In the first installment of this series I explained that our tendency to make poor financial decisions is innate:  it comes from our ancestors.  In the second session I showed you how our behavior hurts investment returns.  Today I'd like to share with you some strategies that financial planners use to close this behavior gap.

The first strategy is diversification.  A diversified portfolio is composed of many different asset types like stocks and bonds, and also different securities within a type like GE versus Exxon.  The idea is that while all of these assets will fluctuate in value, they will do so at different times and at different rates so that the swings will tend to cancel each other out, making the overall portfolio fluctuations smoother. A Diversified portfolio does not guarantee a profit or protection from losses in a declining market. Therefore, the benefits of diversification will hold only if the securities in the portfolio do not react to market events in a similar fashion.

Advisors also use the 'tea saucer' strategy.  Just as people used to pour their hot tea into their saucer to cool it off, your advisor encourages you to route all trades and transactions through him or her.  The result is that you always have a conversation with someone who is well informed and less emotionally involved before making a move.

Finally, financial planners make sure that your mix of investments is appropriate for both your psychological and financial health.  They work hard to ensure that the riskiness of investments is appropriate for you and your circumstances and to set expectations for the volatility you should experience.  Knowing what to expect helps us to better manage our emotional response to events.

At the end of the day you make the decisions for your investment future.  Your advisor's job is to make sure that you have the best possible information and advice available when you need it.  All the better to keep that inner cave person at bay.