History and many worthy investors' track records will tell you that options for making money through investing are endless. Likewise, though, there are many, if not more ways to lose money or languish with mediocre returns. When returns are not satisfactory the investor will often search for a new way to invest. One way we see this is human tendency to buy high when an investment is favored by many and sell low when an investment has fallen on difficult times.
One study by financial services market research firm Dalbar* looks back at 20 years of investment returns. In 2010, the average stock investor received gains of 3.8% over the previous 20 years while the average stock fund gained 9.9% annually. Whether from a lack of discipline of decisions driven by emotions, the consequences were monetary and real.
Chart Source: Davis Funds. *
To combat the pitfalls of investment psychology, defining your process in advance is critical. You may know what you want to do -- seek investments that make money. But how will you go about this and what will you do when the going gets tough?
Have you defined your investment process? If working with an investment professional, do you understand the ground rules that help to influence the recommendations you receive?
What are some important questions to answer about process?
- Asset Allocation: What types of securities will you own? How will you divide up your investment pie?
- Tactical Allocation: Will you make adjustments based upon the rise and fall of the economy or opportunities that present themselves?
- Types of Investments: Will you invest in individual companies' stocks and bonds or pooled investments? Indexes or actively managed vehicles?
- Buy Process: How do you decide what is appropriate to purchase for your portfolio?
- Sell Discipline: When will you decide to eliminate an investment?
- Rebalancing: Will you make adjustments based upon the ebb and flow of values? How will you handle dividends -- reinvest or pay to cash?
In the coming weeks, I will seek to lay out some observations on each of these subjects. This is not meant to be a recipe book for investments but will provide a list of questions for you to think about as you manage your portfolio.
* Dalbar information: Quantitative Analysis of Investor Behavior by Dalbar, Inc. (March 2011) and Lipper. Dalbar computed the “average stock fund investor” returns by using industry cash flow reports from the Investment Company Institute. The “average stock fund return” figures represent the average return for all funds listed in Lipper’s U.S. Diversified Equity fund classification model. Dalbar also measured the behavior of a “systematic equity” and “asset allocation” investor. The annualized return for these investor types was 3.6% and 2.6% respectively over the time frame measured. All Dalbar returns were computed using the S&P 500® Index. Returns assume reinvestment of dividends and capital gain distributions.
The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Past performance may not be indicative of future results.