Wednesday, July 11, 2007

Why Most People Get Returns Less Than The Market

Seven Money Mistakes to Avoid by Smart Money shares some interesting facts on behavioral economics for investors. The article notes that:

"From 1986 to 2005, the Standard & Poor's 500 returned 12% annually, but thanks to overzealous trading, the average investor in stock mutual funds made just 4%, according to Dalbar, a Boston-based financial-services research firm."

Some key behavioral reasons were:

  1. Loss aversion. Quick to sell winning positions but slow to sell losing ones. This often results in low gains and high losses, which reduces one's overall returns. I've done this many times myself. I have ridden several stocks, Southmark, Richton International and Genta (GNTA), to no or almost no value. On the other hand, I have sold a stock, Intercontinental Exchange ((ICE), for a 50% gain only to see it increase to 400% gain a year later.
  2. Overconfidence. Frequent trading or investing only in a small basket of "sure winners." Frequent trading increases commission costs and a small basket of stocks increases risk and volatility. In the past, I have been an anxious trader, especially with sharp changes in the market, and selling stocks to capture the gain. Sometimes, I end up buying the stock back at a higher price, missing on some gain and paying a 2X commission.
  3. Herding. Buying the latest winner or hot tip from the crowd. By the time one hears the news, the run up is usually over. There have been at least a couple times that I've bought stocks from "can't miss" list only to find out that they do miss :-( Globalstar, a satellite phone company, was one such example. It created a satellite infrastructure, went bankrupted, and was bought up for cents on the dollar. It is now a thriving company. Unfortunately, I bought when it was a hot stock, before bankruptcy was declared.
Since I've been guilty of all three of of these, I have likely reduced my returns over the years. For the other four, read Seven Money Mistakes To Avoid. If one is new to investing and want to avoid these mistakes, a great approach is to buy a diversified mutual fund and use this simple strategy to decide which one to buy and when to sell.

For more on The Practice of Personal Finance , check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2007 Achievement Catalyst, LLC

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