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Why does the average investor earn returns far below the market return? It turns out that our natural instincts often lead us to make poor financial decisions. “Why are we such Lousy Investors?” is part one of a four-part series that explains why, and what you can do about it.
The Center for the Research of Security Prices at the
has records for NYSE prices dating back to 1922. They tell us that over the past 90 years or so of booms and busts stocks traded there have earned an inflation adjusted annual average return of over 7 percent. Yet according to an article in the Journal of Finance by Alok Kumar of the University of Chicago , the typical investor earns far less on his stock investments. Why is this? University of Texas
The answer starts in dark prehistory with our cave man ancestors. In those days scattered bands of humans hunted and gathered their way through life, following the food supply from place to place. To survive in the land of the Mastodon and Saber Tooth Tiger required finely tuned senses and hair trigger reflexes: the difference between lunch and being lunch was often only a few inches or seconds. This threat environment also caused us to develop a predisposition to 'follow the herd': in a world full of predators it was not safe be alone. And wherever the crowd was headed was probably where the food was anyway, so it paid off to pay special attention to what your neighbor was doing.
Anthropologists tell us that the skills that helped us survive the Serengeti have been passed down to us today. The only problem is that today's world is no longer filled with large hairy Elephants. It's filled with computers and investments. And the skills and tendencies that allowed our ancestors to get us here alive aren't necessarily the ones best adapted for today's complex, advanced economy.
Take for example those finely tuned senses and hair trigger reflexes: in a world where threats are a little less obvious than a charging Rhino, they cause us to overreact: stocks go up? Buy! Down a little? Sell! Nothing happening? Move my money! Our bias is for action, which makes it hard for us to be patient and tolerate the ups and downs that come with investing.
And our highly developed ability to perceive our neighbor's intentions and actions? Well they too get us into trouble in the world of IPods and pads. Is everyone selling? Buying? Flipping
real estate? Florida
It's called the 'behavior gap' and it costs investors tens of billions every year.
In the next few videos I will take a closer look at the behavior gap and what we can do about it. First, I'll take you through an example of why our impatience yields such poor results. Then we'll talk about tools and techniques that Financial Planners use to help mitigate our natural tendencies. Finally, we'll share with you a way of thinking about your financial affairs that will make it easier to ignore that cave man or woman that lurks inside each of us.