When it comes to investments, we all know that we’re supposed to buy low and sell high. Remember how Derek was able to flip a truck on Craigslist in two months? The extra $1,350 certainly helped him achieve his goal of paying off his mortgage last year. But, many of us try to do the same with our investments in the stock market…and we’re terrible at it. Instead, we make the top investor mistake. We buy high, and we sell low.
In 2012, investors pulled out $93,677 BILLION dollars out of the U.S. equity market. The return in 2013? 35.04%. That’s a huge opportunity lost right there.
Investors regularly make less money than the mutual funds they invest in. They might buy the right investments, but they consistently sell low and buy high. In fact, when you compare what a particular investment (like the S&P 500 index fund) returns vs. what an investor (you) makes in any given time period, the index fund regularly performs better.
Investment researcher Morningstar measures this difference. From 2003 to 2013, U.S. equities returned an average total return of 8.18%. But investors made only 6.52% over the same period. That’s a difference of 1.66%.
As the investments become more volatile (the price swings between higher highs and lower lows), the gap between investor and investment widens. In international equity funds, the average 10 year total return for investments was 8.77%. Investors only made 5.76% over the same time period. That’s a difference of 3.01%.
How to Avoid the Top Investor Mistake
As an investor, it’s crucial to manage your investment portfolio in such a way that you prevent yourself from making the top investor mistake: buying high and selling low. As Carl Richards wrote in his 2012 book The Behavior Gap, the hardest task for any investor is to manage your own behavior. Trick yourself to behave better so you can close the gap between investment and investor performance.
1) Don’t be too risky
Investments with more risk offer more return — but they often have bigger ups and downs in price. With more volatility comes that top investor mistake again: buying high and selling low. With higher highs and lower lows, trading can get very emotional, and cause investors to exit the market at its lows. Compare the performance and volatility of a 100% stock and 100% bond portfolio.
From 1926 to 2014, the 100% stock portfolio earned an average annual return of 10.2%. But in its worst year, the entire portfolio dropped in value by 43.1%. Imagine if you had $100,000 in your portfolio in 1930. One year later, you’d have about $43,000. That loss would hurt. More than half of your entire life’s savings was gone. You might think it was a mistake and pull money out of the market (which would most certainly qualify as a top investor mistake).
Compare this to the 100% bond portfolio. In this case, the portfolio earned an average of 5.5%, or about half of the stock portfolio’s performance. But the worst year saw a drop of 8.1%. That’s about a fifth of the worst year in the stock market. The return is lower, but the volatility is lower as well.
When it comes to choosing your investments, choose a mixture of investments of stocks, bonds, and other investments. This mix is called your asset allocation. Make sure you choose an asset allocation that will allow you to sleep at night, even in the worst bear market.
Once you’ve chosen your asset allocation, make sure to rebalance at least once per year. By setting up a rebalancing plan, you’ll force yourself to buy low and sell high.
Rebalancing works like this: let’s say you’ve chosen a portfolio of 50% stocks and 50% bonds. If the stock market had a really great year, you might end up with 60% stocks and 40% bonds. When you rebalance, you’ll sell the extra 10% in stocks, and put it towards buying more bonds to get back to your 50/50 portfolio. You’ve sold the higher performing asset (stocks), and bought the lower performing asset (bonds). In other words, selling high and buying low.
If rebalancing sounds intimidating, look into target date or lifecycle funds. These funds rebalancing automatically so you don’t have to.
3) Set It And Forget It
Investing for retirement is a long term game. It matters little whether or not your portfolio has gone up or down on a daily, weekly, or even yearly basis. Instead, what matters is that you continue to invest in the market over the long haul.
Take the daily decision making and worry out of investing. Instead, set up automatic transfers from your paycheck into your 401(k). Automatically invest in your ideal asset allocation. If your 401(k) offers automatic rebalancing, go ahead and take advantage of it. With your long term investments on autopilot, you can feel secure knowing that your future is taken care of regardless of what is happening in the market on a day to day basis.
Related: Invest Wisely with Personal Capital
When we save money for retirement, we hope we’ll be able to keep it there forever. But sometimes, unfortunate things like job loss and sickness happen. And if you lose your job in the middle of a recession, you might need the money even though your investments are down. That’s why it’s wise to keep some amount of money out of the market in a safe place. It will be there when you need it, and your investments can keep on growing.
5) Ignore The Financial Drama
Whether it’s T.V., the radio, or the Internet, there’s always news about a potential disaster in the financial markets. But on a day to day basis, very little of the news applies to your life.
The European debt crisis is causing the European market to tank? So what? If you have international investments, your portfolio will eventually re-balance, and you’ll pick up those investments while they are still on sale.
Your day to day life is still the same. You still have the same hopes, dreams, and obligations as yesterday. If your long term goals are the same, your investment strategy is the same, no matter whether the market is up or down. If the T.V., radio, and internet are making you paranoid, turn them off!
The Bottom Line
Investing is an important part of reaching your long term financial goals. But realize that the biggest impediment towards reaching those goals is you. Instead of relying on your smarts to time the market, set up a system so you’ll avoid the top investor mistake of buying high and selling low.
Have you made the top investor mistake before?
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.