Behavioral finance is a fascinating field to me. It’s the study of how our emotions and judgment can affect decision making with regard to investments. In the time I have spent advising people on their investments, I have witnessed the power fear and greed can have over logic and reason. The good news is that the more we understand where our intuitions and biases come from the better chance we have at making good investment decisions.
Studies continue to find that investors earn lower returns than the funds in which they invested. Dalbar, a market research firm, issued their 2011 report showing investors achieved a mere 41.9% of the S&P 500‘s performance over the twenty years ending December 31, 2010. In other words, investors managed to leave a staggering 58.1% on the table. What could possibly explain missing out on these returns? It is largely due to investor behavior.
The goal of investing is to buy low and sell high – that’s a given – but our emotions, intuitions, and bias frequently work against us. Most investors did not begin buying technology related stocks in the early 90’s when prices were still reasonable; the vast majority bought in the late 90’s at astronomical prices, just before the “tech bubble” burst. Similarly, it was incredibly difficult to keep many investors positive about the prospects of the future during the first quarter of 2009 – the market bottomed on March 20, 2009 from the “housing bubble”- just before the markets began a climb to double in less than 2 years.
I recently read a wonderful new book written by Larry Swedroe & RC Balban, called “Investment Mistakes Even Smart Investors Make, And How To Avoid Them,” and I think it’s worth adding to your reading list.
I won’t re-write their book for you here, but Swedroe and Balban have done a great job of compiling a list of the most common mistakes and what you can do to avoid making them. This book will help you better understand why our investment strategies work, even though they can sometimes seem counterintuitive.
If you are not a client of ours and are considering hiring an advisor, this book may help you understand the mistakes a disciplined investment strategy can help you avoid.
By studying history and behavior, we can learn to avoid the same mistakes in the future. We can also understand why the disciplined investment decisions are sometimes the most uncomfortable. If we do our job well, you’ll be encouraged to stand by them anyway, knowing that discipline will pay off in the long-run.