Faults of the Individual Investor to Avoid (Reasons for Impartial Advice)

Individual investors historically act as a contrary indicator. That is, looking at recent events, they assume that a market going up will continue to go up, or that a falling market will continue to fall. The individual investor fixates on the past, as if it will continue, rather than gauging the future. With this perspective, the behavior of the individual investor is to buy at the peak and sell at the trough, hence making them a contrary indicator to what will really occur. Countering this behavior takes substantial discipline, experience and information, and usually a good advisor.

A good advisor should add value through asset allocation and fund selection, but foremost by guiding you to counter bad investment behaviors. You need to stay invested when you fear a fall and sell when you are convinced of sure upswings. Advisors need to provide value-added guidance that will:
(1) avoid giving any serious weight to short-term indicators;
(2) avoid trying to pick “winners”;
(3) closely examine expenses, as high costs result in much lower net returns;
(4) investigate riskier classes as a component of a good overall asset allocation (e.g., emerging markets);
(5) look for funds that stick to their own goals, rather than trying to match any index, as such discipline pass off over time;
(6) take a contrarian view at times because too often a fund doing well at a given time will ultimately revert to the mean of all funds; and
(7) be clear with clients on the risks being taken (that is, measure the risks for say a bond differently than stocks).
All these are ways in which advisors increase the chance that you achieve good investment returns over time.

Recent history provides a good example. With the crash in 2008, we spoke to many clients and started a flow of e-mail updates and strategy suggestions. This became our newsletter on our web site. The key advice was that, if you have a good allocation, and good investments, stick to your long-term plan, do not sell. Those of our clients who followed the advice returned to their pre-crash peak values by last year, something none of us thought would be possible so soon. However, those that sold were selling as investments declined in value. Moreover, they had no clear signal in mind as to when to reinvest. That meant that most missed the rise of greater than 11% in the beginning of 2009. That upswing can never be regained. Therefore, they sold at a low point and were forced to buy back in at a higher point.

How could those that stayed invested be back to their peak when most indices have not returned to their all-time highs? A well-managed portfolio, employing good asset allocation, will not drop as much so it will have less to recover to be “whole.” Therefore, it could regain its peak value more easily, and with less risk. Again, this points to all that we have published before on the need for asset allocation analysis and diversification within each investment type as well as among investment types. It also makes clear how important not losing capital is: losing 50% requires a 100% gain to recover, while losing 25% takes only a 33% gain.

Good investing will lead you to avoid the behaviors that constitute what Carl Richards dubbed the “Behavior Gap” (April/May issue of Morningstar Advisor), meaning the gap between investment returns and investor returns. Simply opting for index funds is not a quick fix that works. Instead, individual investors require guidance. They can have the best possible investment approach “only to blow it up completely with one big behavioral mistake at the wrong time.” He goes on to write that all approaches are tested over time, so the advisor’s role is one of helping “rid the world of negative behavioral alpha, to close the Behavior Gap.”

In another article, he writes that “ … if 83% of mutual fund investors are getting advice from advisors and are doing poorly, maybe we advisors are part of the problem. (See First, Do No Harm by Carl Richards 02-10-11) To state the opposite side, “Still the trend seems clear. Investors who were inclined to invest for the long term were likely to have better returns. A look at how the markets have worked during the past 10 years illustrates why that is. We had two bear markets and two dramatic rallies. Those who sold equities in the bear market missed out on the rally and therefore nearly all would have been better off riding out the bear market.” (Inside the Vanguard Science Project Vanguard’s more-patient shareholders outperformed the rest. by Russel Kinnel 05-05-11)

Investors doing all the work with no advisors have access to good tools, such as E-Z Planner for retirement planning, but that can be dangerous. Again, the risk of bad input, generating bad outcomes, comes from the same issues of perspective and bad investment behavior. With an objective source to counter your own bias or “bad investment behavior,” this can be avoided. For example, in addition to the investment issues reviewed above, most individuals understate spending. “Oh, yes, we did buy [something] last year, but that was a one-time event.” Each year will have “one-time” events. Building a good plan takes some means by which tough questions like cash flow and investment risk are addressed. Otherwise, the best software will produce results with erroneous conclusions.

Conclusion
You need terrific discipline or good advice to resist psychology of risk aversion and the urge to use recent events as a gauge for what will occur next. Otherwise, your investor returns will fail to match investment returns over time.

Having said that, what is the Next Step:
First, review how your portfolio performed in recent times, did you react from fear and leave your strategy or hold on?
Second, review your portfolio; does it fit your risk tolerance and financial goals?
Third, take a second look at your portfolio, but from a contrary perspective; did your answer on risks match the actual investments made? (For example, someone claiming worry about the economy should not be 80% in US stocks.)
Finally, check to see if the portfolio, with any on-going savings, will be sufficient to achieve your financial goals. If you are not certain, then advice from an objective source could make a substantial, and very important, difference.

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