How would you feel if I were to tell you that your whole investment foundation was built on a lie?
The thing is, it’s not a blatant lie. It’s a simple philosophy that many of us subscribe to without realizing how false it is and how damaging it can be to our investment future.
Here’s the big fat lie that many advisors tell their clients: The performance of your investments is the key factor in a successful retirement strategy.
See? It seems harmless and common sense, but it’s far from the truth.
Now for the truth. Your retirement plan’s success does not hinge on whether or not your portfolio beats the market, or some arbitrary benchmark like the ubiquitous, “always-in-your-face-on-the-internet” S&P 500 Index.
All advisors want to tell their clients that their particular choice of investments outperforms the investments of their competitors. Yet, how can that be true? How can all advisors, in aggregate, be above average? It’s simply not true over the long-term.
What really affects returns is the behavior of the owners of those portfolios. It turns out that how we behave–particularly during market exuberance and its inevitable crashes–has a big impact on our financial success. And paradoxically, chasing the mirage of outperformance–no matter how hard we try–usually leads to below average returns. It’s one of the few areas of life where above average effort can actually lead to below average results.
Harmful Behavior = Poor Returns
A 2015 DALBAR study, “Quantitative Analysis of Investor Behavior,” showed just how poorly investors perform relative to market benchmarks over time. The primary reason for underperformance by investors participating in the markets? Their decisions. That is, behavioral pitfalls lead to poor investment decision-making. Once you understand some of the common behavioral traps, they become preventable, which is why we blog so much about this somewhat “touchy feely” stuff.
Emotional investment decision-making is a real thing. Investors freak out when the market goes through its usual ups and downs. They panic. They buy high, sell low, and put their finances in jeopardy. It’s well documented in Neuroscience that sharp market declines can trigger reactions similar to seeing a deadly snake in the grass, which lights up more primitive parts of our brain.
Not an ideal state of mind for optimal decision making.
How do you fall prey to this kind of behavior? When you have an investment strategy, but not an investment philosophy. A strategy without the foundation of a sound philosophy will not hold up when the shit hits the fan. But, if your approach is guided by a firm philosophy grounded by your values and backed up by academic evidence, you won’t be swayed when the market melts down.
Evidence-based investing trumps emotional-based investing, every time. Here’s a fact to remember when the market news starts to wear you down: return-chasing behavior led to 5 percent annual damage from 1984-2012 (I didn’t make this up…it’s from the Federal Reserve).
How Important is Behavior?
Here are some more facts for you to chew on (and hopefully persuade you to stop managing your money like a player and more like a coach):
DALBAR’s research shows a consistent relationship between the most recent 20-year average compound rate of return of the average large-cap mutual fund in the U.S. and the average return realized by the average equity mutual fund investor.
Over 20 year periods, the average fund investor ends up with less than half of the return of the average fund. So, if investors were to hire a fee-only advisor that focuses on optimal behavior–not selling products or trying to beat the S&P 500 with their “superior investment selection”–they’d improve their returns drastically.
What To Do?
Create an investment philosophy first, then pair it with a strategy that is focused on your goals. Importantly, your goals are long-term and not resting solely on what is happening in the daily market craziness.
I used to be an engineer. So I love equations. Here is your equation to stick to:
An evidence-based investment strategy + appropriate allocation and global diversification + successfully managing behavior = 95% of real world returns over time.
And don’t forget, working with a trusted, fee-only financial advisor who understands that investor behavior is the key determinant of financial success can help you achieve higher returns by avoiding mistakes.
Here are some top-notch behaviors you can implement to increase your returns:
- Keep a long-term focus. The markets fluctuate every day. You’ll only feel increasingly stressed and make more emotional decisions if you monitor your performance and adjust your investments every time something scary happens. It’s vital to keep a long-term perspective and a disciplined approach.
- Keep fees low. It’s basic math: Gross Returns – Costs = Net Return. Avoid investments with high costs or hidden fees, which can drastically eat away at your assets over the long-term.
- Rebalance. I like to meet with my clients at least once a year to review their portfolio and rebalance as needed. This way, you can have confidence that your portfolio still reflects your appropriate level of risk and is adjusted for any significant changes in your life. If you have a long-term investment horizon, there’s no need to rebalance more often than that.
The Performance Measurement That Does Matter
When it comes to investing, what matters most is not market performance or this year’s hot stock picks; it’s applying the right behaviors to a personalized strategy based on your specific goals, needs, and values.
Has your financial advisor talked to you about how investor behavior is what makes or breaks financial success? Have they mentioned how it is addressed in your retirement strategy? Or were your pitched on a value proposition built on the lie of outperformance?
Have you signed up for our free 14-Day Plan to radically improve your finances and investments? Our powerful, easy to implement ideas will yield BIG results over time. If you are too busy, just pick one or two of our recommendations and do them this month. Try it.
Pathway founder and principal Greg Brown is a tech-savvy advisor with broad financial planning and investing expertise. Greg’s financial advice has been featured in publications like the Wall Street Journal, Businessweek, and USA Today. He holds a master’s degree from the University of Chicago and a mechanical engineering degree from Michigan State University. Prior to Pathway, Greg was a lead analyst at Morningstar and previously held engineering roles at Dell.
Also published on Medium.