Home

Behavioral Science 101

Why many people underperform their own investments
Chad Hemphill

From March 2009 to the beginning of 2012, the Dow Jones Industrial Average (DJIA) doubled while investors poured out billions of dollars from their stock investments over the same timeframe.

By looking into what factors led to poor investment decisions and why those decisions were made, we can avoid falling victim to fear.

I try to use graphs as little as possible when explaining investment strategies, but felt these were worth sharing; they are great examples of when and why most individuals underperform their own investments.

The chart on the left begins on March 9, 2009, at the bottom of the Dow Jones Industrial Average (DJIA) over these past three-plus years, and goes through the beginning of 2012. The chart on the right covers the same timeframe and depicts the monthly flows of US stock mutual funds among individual investors. In this three-year time span, the DJIA doubled while investors poured out billions of dollars from their stock investments over the same timeframe.

This time in history is fresh in our minds and many of us still feel the lingering fear and uncertainty. A great article was written by smartmoney.com titled Main Street’s $100 Billion Stock Market Blunder. The article shows how it was not the investments themselves that lost money, rather the investors’ and their advisors’ timing crippled their portfolios.

The next logical question is “where did the money go?,” which is where this story goes from bad to worse. The majority went from the stocks into bonds under the illusion of safety as reported by Credit Suisse Group. A little background on bonds here is important: bonds are a loan of your dollars to a government or institution with a promise to pay you back your principal some date in the future (term) with interest accruing until maturity. The current yield on the 10-year Treasury bond is 1.97% at the time of this writing. The majority of investors depicted in the graph on the right who sold were willing to give a ten-year commitment of their money for the right to earn 1.97% per year for the next ten years.

At what point in our history or our parent’s history can we remember being willing to lock up our dollars for ten years for less than a 2% return? I can’t find one where interest rates were this low with willing buyers. The major risk in bonds right now is the interest rate risk. Bonds have an inverse correlation with interest rates; if interest rates go up, bond prices will go down. This is no small point, and bears repeating; as interest rates rise, bond prices fall. I cannot predict when interest rates will go up, but eventually they have to; this will lead to a double slaughter for those investors who have already been negatively impacted by poor timing with their decisions to sell stock investments.

These graphs are a very real depiction of what many investors have been experiencing. I see or hear about it almost every day in meetings. We cannot dismiss the fear; instead, we must understand it for what it is and face it head on. Going through – rather than giving into – this fear is of utmost importance. We cannot be scared out of our portfolios during times like these because we have too much at stake.

The safe, high yielding investment that is being broadcast on the front of offices across St. Louis and in the financial media and gives the illusion of no risk (i.e. 20-year bond rates) is just that – an illusion. It is the unicorn of financial planning; there is no such thing as free return for little risk.

Americans have grown up with many investing myths. One of the most misleading is that there are only two goals of investing: 1) growth that is treated as risky and 2) income that is considered safe. This myth has never been more farfetched than in our current environment. In my experience, to the investor in the midst of a 25+-year retirement or those who are passing assets that may send their grandchildren to the college institutions of their choice, only one rational investment objective is important, and that is the “growth of income.” Bonds by their very nature are not designed for that, and today’s environment makes seeking growth of income from bonds a very poor strategy.

It is a simple fact, but one that we often override with bad choices brought on by fear.

There is no “unicorn of financial planning;” no single perfect solution. Proper planning based in facts over fear, however, may help you avoid making rash decisions that could be detrimental to your portfolio’s long-term growth.

Please note that stock investing involves risk including loss of principal. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. Investing in mutual funds involves risk, including possible loss of principal.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individual and institutional investors.

__________________________________________________________________________

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is not guarantee of future results. All indicies are unmanaged and cannot be invested into directly.

If you have a suggestion for a topic to address in an upcoming newsletter, let us know. We’d love to get your feedback.