Wednesday, August 4, 2010

Why are we such lousy investors? Episode 2: What the Behavior gap does to returns


Landing Page Description:
Why does the average investor earn returns far below the market return? In part two of this four-part series, we show exactly how ‘normal’ investor decision-making can turn a great investment into a poor return.

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. Today I'd like to explain to you just how that behavior leads to poor returns.

Imagine two great investments: they both go up 10% every year without fail. But you don't know that, so you decide to 'lock in' your return every year by selling one and then buying the other. What happens? Well first you pay a transaction fee and if it's in a taxable account, you pay taxes on the capital gain. So let's say you end up with only 8% of the 10% gain that you had. Then you buy the other fund. You do this every year, jumping from one to the other. After twenty years your investment would be 430% larger. Pretty good, but if you had stayed in one investment for all ten years and then sold it, your total after tax return would have been 580%. We call it "excessive trading" and it's one source of the behavior gap.

But it gets worse. When we jump out of an investment we almost never jump into another similar one. Instead, we 'sit on the sidelines' with money in low yielding money market accounts for 2, 4, 6 months before we reinvest it. The result? We lose the benefit of the time that our money could have been working for us. By waiting just 3 months to reinvest the money each year in our example, the ten year return falls from 430% to 353%.

But it gets even worse than that. I'll let you in on a little secret: there are no perfect investments. It's much more likely that our two investments will swing up and down in value depending upon circumstances and market sentiment. So lets say they rise 20 percent and then fall 10 percent every year. Our tendency to pay too much attention to our neighbors leads us to buy when it's rising and sell when it's falling - after all, that's the reason it rises and falls so much: everybody's doing it. This tendency to do what the crowd is doing is euphemistically called 'momentum' investing, but the momentum it provides to the typical investor is usually down.

Excessive trading, sitting on the sidelines and following the crowd: three  ways to reduce your investment returns because of the behavior gap.

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