Nothing defines humans better than their willingness to do irrational things in the pursuit of phenomenally unlikely payoffs. This is the principle behind lotteries and dating…”
– Scott Adams, creator of the comic strip Dilbert
UPDATED May 2016: With full confidence, I can say that you are irrational when it comes to investing.
I know this not from talking to your broker or your mother-in-law, and I haven’t hacked into your portfolio statements. I know this because you’re human.
What will happen in the stock market isn’t predictable. But one thing is absolutely for sure and for certain: Investors are predictably irrational. We’re not talking smart or stupid, sophisticated or naïve. We’re talking across-the-board irrational.
So maybe you’re thinking that you’re the exception. You think you can handle the volatility of the market by just gritting your teeth and praying everything turns out all right as you roll the dice in the Wall Street Casino. Or maybe you think that at the first sign of trouble, you’ll be able to bail out of stocks and into bonds or money market funds to lock in your gains.
Researchers say, “Nope, that’s not what’s happening…”
As I point out in Chapter 2 of my best-selling new book, The Bank On Yourself Revolution, history shows that most of us are far more successful at locking in our losses than our gains. Since 1994, DALBAR, Inc., the leading independent, unbiased investment performance rating firm, has studied the actual long-term results investors get in the market. In the 2015 Quantitative Analysis of Investor Behavior, they concluded:
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The average investor in asset allocation mutual funds (which spread your money in a blend of equities and fixed-income funds) earned only 1.76% per year over the last 30 years!
These investors didn’t even come close to beating inflation, which averaged 2.7% per year.
- The average investor in equity mutual funds averaged only 3.79% per year – beating inflation by only 1% per year. (Was that worth the roller-coaster ride and sleepless nights?)
- And the news just gets worse: The 3.79% return investors in equity funds got over the last 30 years was almost two-thirds less than the return of the S&P index over that period!
- Pity those who invested in fixed-income funds. They only managed to eke out a .72% annual return, significantly trailing inflation and getting only a small fraction of the return of the corresponding benchmark.
Shocking, isn’t it? But if you’ve noticed your investment accounts aren’t rising at the rate of the market, you recognize the truth of those numbers. How is it even possible for so many people to underperform the market indexes like that?
[Investor returns continue to drop, as this article about the latest Dalbar results reveals.]
The verdict is in: DALBAR, Morningstar, and the behavioral finance experts confirm that the majority of investors consistently buy and sell at the wrong times. Why? We’re human, and we humans make emotional decisions driven by fear (survival) and greed. But as financial writer Brett Arends warns us, “You can’t buy low and sell high if you buy high.” And that’s exactly what too many of us do.
Maybe you think you’ve covered that problem by putting your funds in the hand of the professionals.
Really? Here’s a quick quiz…
Q: What percentage of mutual funds, financial advisors, and investment advisory services underperform the overall market?
A: 80%, according to the Hulbert Financial Digest. And it’s not just because their fees reduce any profits. It’s because all the experts are human, too, which means they are predictably irrational like all the rest of us, buying and selling at the wrong times.
In his book Predictably Irrational, behavioral economist Dan Ariely explains how we human investors typically forget about our losses and mentally exaggerate our successes. (You gotta love the name of the institute Ariely co-founded: The Center for Advanced Hindsight.) He says,
It is true that from a behavioral economics perspective we are fallible, easily confused, not that smart, and often irrational. We are more like Homer Simpson than Superman.”
The Dalbar Report revealed we face other challenges as well:
- “Attempts to correct irrational investor behavior through education have proved to be futile. The belief that investors will make prudent decisions after education and disclosure has been totally discredited”
- “Risk tolerance is subject to many variations and must be monitored regularly to keep investments aligned. Changes in risk tolerance make any attempts at automatic rebalancing futile at best and may result in unnecessary losses”
Okay, okay, so maybe you are the exception. Maybe you’re the one in a zillion, that Superman or Superwoman, who remains calm, cool and collected as the market flips, blips, flash crashes and throws its tantrums. The problem is that you’re the one sober driver on a highway that’s loaded with drunks behind the wheel – how can you protect yourself from what they will do?
In the Wall Street Casino, we’re playing at a poker table that has its own inherent risks and uncontrollable odds against opponents whose moves are based on raw emotion, not the cards they hold.
It doesn’t matter if you’re following the brilliant analysis of the most precise and accurate economist. The rest of the market isn’t.
So what can you do about it? According to professor Dan Ariely, “Even the most analytical thinkers are predictably irrational; the really smart ones acknowledge and address their irrationalities.”
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