According to the DALBAR, Inc. Quantitative Analysis of Investor Behavior report, most retail investors:
- Feel twice the pain of a dollar loss than pleasure of a dollar gain. This is referred to as Myopic Loss Aversion by experts in Behavioral Finance. There’s nothing wrong with having a heightened sensitivity to the possibility of losing money, as long as it doesn’t interfere with the ability to make good investment decisions. But the data shows that most investors do let this loss aversion get in the way.
- Focus more on avoiding down markets than participating in up markets (for example, a retirement plan invested only in money market funds.) Which is worse: being invested in a declining market, or not being invested in a rising market? Answer: they’re equally bad. But most investors don’t see things that way. They don’t view opportunity cost (being in cash when the market is rising) as somehow less real than actual paper losses. In fact, a paper loss is a paper loss regardless of which way the market goes.
- Fear making any mistakes even though professional investors make plenty. This fear is often paralyzing at exactly the wrong time. The markets are constantly presenting us with opportunities to buy low and sell high. But investors who are too fearful of losing money often balk at buying when prices are cheap. This leads to severe under-performance by retail investors in general.
- Project short-term investment performance, bullish or bearish, to infinity. Finance experts call this “extrapolation.” It comes from the conventional wisdom that says what happened in the past is likely to continue to happen in the future. This is true for many aspects of our lives, but in the world of investing, it’s a dangerous misconception. There is no evidence to support the claim that stocks that have gone up recently will continue to go up, or vice versa.
- Tend to “fight the last war.” I see this all the time in my coaching practice. When a major market event takes place, investors tend to believe that the event in question is bound to repeat itself again in the near future. For example, there is a widespread belief among investors today, that the U.S. is about to fall back into a ‘double-dip’ recession. Yet, the evidence is much more supportive of the opposite outcome. This fear of history repeating leads investors to wait longer than they should to get back into the market after a big fall.
- Focus too much on companies or industries that they are familiar with (only company stock in a 401K.) There are approximately 8,000 stocks in the U.S. market to choose from, yet most investors limit their horizons to just the companies they are familiar with. This familiarity bias is a significant limitation on potential opportunity. Peter Lynch was a famous advocate of buying stock in companies that you know well, but he was actually giving bad advice.
- Slow to sell a losing investment, but quick to cash in on a winning one. One of the most difficult thing for many investors to do is to resist the temptation to sell a winning stock. This tendency to ‘cash in’ on your winners comes from a desire to avoid the regret that would come from watching those paper gains evaporate if the stock were to go back down again. The fear of regret is many times stronger than the desire for gains for many investors.
- Have difficulty balancing risk and reward, often going to extremes. For many investors, it’s a matter of “all in” or “all out.” But going all out (selling your stocks when you’re afraid of a market decline) is actually an extremely risky strategy. Why? Because you are placing all your chips on a single asset class – cash – and that’s never a good thing.
These are just some of the most common behavioral mistakes that retail investors make. The end result of falling victim to these errors is that the average retail investor only captures about 3/5 of the gains that the market offers. The long term average return of the market is about 9.5%, but the average investor only makes about 5.4%.
One way to improve your results would be to pay attention to the thought process you go through the next few times you make an investing decision. Look for the traps and mistakes listed above. If you can identify one of these mistakes before you do the trade, you can re-think your strategy and possibly save yourself some money.
Of all the mistakes investors make, the most costly one is going ‘all in’ or ‘all out’ when the market goes to extremes. Try to bring more balance to your portfolio by making a rule that you will never go all in or all out. If the market looks very scary, consider selling just half of your stocks instead of all of them. That way, you won’t be severely punished if you end up being wrong.