Just like drivers on city freeways, many investors tend to frequently change to what they perceive as the fast-moving  lanes of the investment markets.  As with driving, the fast-moving investment lanes can become the slowest and the slower-moving investment lanes can become the fast-moving ones again.

 The problem is that by the time that ”hot” investments are recognized by investors, they have already increased substantially in price—whereas the investments being sold have decreased in price and are now good buys. As a result investors end up buying high and selling low as they chase performance—exactly the opposite of what investors should be doing. This is by far the biggest and most common mistake investors make. It is costly, potentially risky, and can greatly detract from investment returns.

 Numerous studies by major investment informational resources including DALBAR–a leading financial services market research firm, and the Hulbert Financial Digest--a highly respected independent authority on published investment advice, show that the typical investor earns far less than reported returns for mutual funds.

 For example, according to DALBAR, the S& P 500 Index’s average gain over the 20 years ending in 2008 was 8.4%/year. The average investor in mutual funds obtained only 1.9%/year during the same time period!  The same is the case for fixed-income investors.  The Barclays Capital U.S. Aggregate Bond Index returned 7.4%/year during the same 20-year period—yet the average investor in fixed income earned only .8%/year!

 How do investors do this to themselves? The primary reason is that emotion, not logical thinking, rules their investing habits. The result is an emotional “herd instinct” that hurts investors time after time. The volatility accompanying strong bull and bear markets accentuates the problem with strong emotional decision making based on fear and greed taking over with excessive buying and selling at precisely the wrong times.  In just the last 10 years we have experienced this twice with the technology and real estate bubbles and crashes.

 Investor’s emotional tendencies are well known in the growing field of behavioral finance.  So what can we do to counter these negative habits and obtain the investment returns the markets provide? One or more of the below strategies can help you discipline yourself and control your emotions for better decision making and much better returns.

• Tailor your portfolio to your risk tolerance.  Get fully tuned in to your risk tolerance and how much “safe money” you need to better keep your emotions in check.  Adding more safe and liquid investments such as bond and money market funds and reducing the stock allocation in your portfolio as appropriate would provide a more stable and less volatile portfolio.
• Establish a separate safe money account.  Consider establishing a separate “safe” money account containing stable, lower risk investments such as short-term bond funds and cash equivalents. Having a separate account with very safe money can help minimize the tendency to emotionally driven investing behavior during volatile markets.
• Incorporate proven strategies to neutralize emotional decisions.  Two of the best strategies to counter emotionally-driven decision making are (1) regular portfolio rebalancing and (2) dollar-cost-averaging. By rebalancing your portfolio’s asset allocation back to your established percent allocations when it gets out of whack, along with regular investing in both up and down markets (dollar cost averaging), you discipline yourself to buy low and sell high. You also maintain the target asset allocation you established that meets your personal needs including degree of safety.

Note: With rebalancing, you are selling part of your portfolio assets that have been the fastest growing (selling high) and using the proceeds to buy more shares of the assets that have not grown in value as fast (buying low). When using dollar-cost-averaging in making regular investment contributions to your portfolio, you can buy more shares when the market price is down than when it is up. Therefore, on the average, you are paying less for your investment contributions—buying low.  As a result, both strategies can greatly enhance portfolio growth potential over time.

Bottom Line & Final Thoughts

1. Portfolio volatility, emotion, and focus on short-term results collectively cause investors to lose objectivity and to make poor decisions.
2. Investors’ behavior often hurts their investing returns to a huge degree.
3. Investors can learn to do much better by (1) incorporating the stability in their portfolios necessary to match their risk tolerance, and (2) establishing disciplined investing strategies to maintain and grow their portfolio by buying low and selling high using rebalancing and dollar-cost-averaging.
4. Major studies have shown that portfolio asset allocation accounts for over 90% of a portfolio’s long-term risk-return performance. Therefore, it is very important to get this right by tailoring it to your specific needs, goals and risk tolerance.
5. The use of index mutual funds and exchange traded funds in your portfolio can help ensure market return performance and reduce the temptation to jump from one fund to another. This temptation so often happens when using actively managed funds as they go through the inevitable “fast to slow” lane ups and downs. Active fund managers can vary greatly in their performance relative to each other over the same time periods. Some can do very well, others not so good—then their relative performance can switch during another time period—it is unpredictable. Additionally, most actively managed funds have not performed as well as the indexes over the long-term–especially when considering their higher management fees.
6. For most individual investors, good long-term investing results come from staying the course with an appropriate individualized mix of both safe and growth-oriented investments, and through the use of the time-proven investment strategies—rebalancing and dollar-cost-averaging—as primary portfolio management tools.