Warning: This is a longer than usual post about investing. If you have absolutely no interest in understanding one of the worst mistakes average investors make, and even better how to avoid that mistake, then stop reading. However, if you are concerned about investing for retirement and making better decisions, this post is just for you.
I’m going to start out here by laying some groundwork. First, we’ll begin with a serious investing problem average investors have. Then move on to how successful investors exploit this problem and make more money from it (at the expense of average investors). Then we’ll move on to steps you can take to help avoid this problem for the rest of your life.
Why This Investing Discussion Will Benefit You
Through this blog I get questions from many readers. Many questions involve investing, such as “What should I invest in?” “What type of portfolio makes sense for me?” etc. I think the main reasons for these questions are:
- Interest rates have been historically low for years now. This has caused investors to seek greater returns in the market, since guaranteed returns just don’t produce much currently.
- The stock market has been very volatile since 2000. Investors want a reasonable rate of return, but they are rightfully scared about investing the wrong way and suffering a big decline in their portfolio (think of the years 2000, 2001, 2002, and 2008).
- There are a huge number of people retiring every day. At retirement they have to do something with their 401(k)’s. And this is the first time they’ve had to be proactive with their investments, and ask the tough questions concerning how to invest this life savings.
With these very economically unique circumstances all coming to a head, investors have turned to the internet to begin the search for answers on how to invest their portfolio for retirement. Fortunately, there’s a lot of good information freely available. Unfortunately, it can be hard to weed through the bad information.
And another unfortunate fact is that even the good investing information available online does not address the biggest problem investors face: controlling their emotions and not sabotaging their own portfolios.
There will be more on that later in this article.
This discussion will take a different approach. Yes I’m going to discuss some standard, solid investing principles. But we’re also going to talk about ways to help overcome the emotions that cause many investors to make big mistakes.
What’s covered in this investing for retirement discussion
In this article I’ll be covering the following information:
- Real life recent examples of short-term market performance that could have derailed the average investor
- Example of arguably the world’s most successful investor underperforming during some economic environments
- Empirical proof that average investors often sabotage their portfolio
- Why successful investors love it (and profit) when average investors make poor investment decisions
- Empirical proof that even institutions can make bad investing decisions based on short-term results
- How to help make better investing decisions, like successful investors
What you’ll find with investing is there is the “head knowledge” of good principles. And then there is the practical knowledge that enables you to make the good decisions in real time regardless of what your emotions tell you. In other words it takes some “grit.”
Before we go any further, for anyone that has found my website for the first time and knows nothing about me, I am a fee-based financial planner. That means I charge a fee for creating financial plans and providing investment advice. I am also licensed to sell annuities and life insurance, but neither of those will have anything to do with today’s discussion.
Here’s a little legal disclosure before we get started:
Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results. Before making any investment decision, do your own due diligence and consult a properly licensed professional if you have specific questions about your own unique situation.
Investing for retirement: A typical scenario
Today I’m going go over some fundamentally important issues investors face when investing for retirement. Many people begin investing early in their careers via a 401(k), 403(b), TSP, or some other type of employer sponsored retirement plan. Contributions into these plans are usually on a “set-it-and-forget-it” basis, with a portion contributed once every 2 week pay period.
Often the choices of investments are made many years ago and are never changed.
Thus when an employee eventually retires, they have a large sum of savings they must roll over into an IRA and begin investing on their own. This obviously raises many questions, as the retiree must now become skilled at being an investor so that they don’t run out of their savings in retirement.
A very common way people will decide how to invest their life savings when they retire is either by asking their former co-workers which advisor they went to. Or by attending a free dinner seminar. At the dinner seminar they get some financial education along with a free dinner. Afterward, the attendees are invited to the presenter’s office for a consultation. Oftentimes what is discussed at this consultation becomes the retiree’s investment plan for their retirement.
I have hosted seminars myself, and as of writing this just recently completed one. They are a great way to meet people and offer financial education to the community. And I believe most advisors doing dinner seminars are offering sound advice. But I also know that not all advisors have their client’s best interest in mind. I have personally talked with people that I know have been deliberately lied to by their advisors (I use the word “advisor” loosely in these circumstances.).
After reading this article, it should help the potential investor be better able to tell the pros and cons of the investment strategy they are being recommended.
Let’s start with some recent history
I’m going to begin with some charts of the S&P 500 during the year 2016. A 1-year period is really a short time frame when it comes to investing. And looking back with hindsight we can see how it would have been very easy for the average investor to get scared, sabotage their plan, and miss out on some good investment results in 2016.
[For those of you reading this post many years into the future beyond 2016, this is still relevant. We are just using this time period as a case study. And the lessons learned from it will still be applicable in the future.]
The first chart to look at is the beginning of 2016. The market got off to a horrible start that year. Here is the chart from Google Finance:
The S&P 500 closed the year 2015 at 2,043. By February 12, 2016 it closed at 1,864. That is a drop of about 8.8% in a 43 day period. Considering the short time frame of that amount of a drop, the average investor could have believed it was the beginning of the next big market correction. However, it was just a blip, and by mid-March, the market had gained back the loss and was hitting new highs for the year.
The next chart shows another short-term correction that occurred. This correction was over Brexit. For those that don’t know, Brexit was the short-hand phrase for Britain’s exit from the EU. It was unexpected, and all the betting websites predicted that Britain would vote to remain in the EU. But such did not happen.
When they exited, the equity markets dropped. In fact the S&P 500 dropped to a little below where it started the year out.
But this also turned out to be a short-term effect. The market rebounded shortly thereafter. The projected effects of Brexit were not only over exaggerated, but they were just plain wrong.
During both of these above scenarios, the average investor could have gotten scared and let their emotions take over and sell out. But then they would have missed out on additional growth.
[Note: this is not saying it was wise or foolish to remain invested during these times. It is only to make the point that looking at purely short-term market corrections can cause an investor to make unprincipled investment decisions. And how you invest your portfolio for retirement needs to be based on principled decisions, not emotional ones based on short-term market corrections.]
Looking back with hindsight we can see that for the short 1-year period of 2016, if the investor had stayed invested (in the S&P 500), they would have seen their portfolio grow 8.63% in capital appreciation. And if dividends were reinvested, the growth is approximately 12%. Not too shabby.
But it’s very easy to see how the average investor could have bailed out of this investment, especially by mid-February. And even again after Brexit. And then once again in November there was a dip when Trump unexpectedly won the Presidential election, catching the markets off guard. Ironically, the equity markets performed very strongly after the election, even though there was panic the day the election results came out. Go figure.
But if the average investor had bailed out in mid-February, they would have not only lost about 8%, they would also have lost on the year’s overall gains of 12% (when considering dividend reinvestment).
Even the best investors can have bad short term results
Another thing that makes investing for retirement difficult is that a good investment strategy can have bad results in the short-term. For instance, Warren Buffett, arguably the worlds’ most successful investor, can have bad years.
Using his company’s stock value (Berkshire Hathaway) to determine his investing success is a good way to measure performance. Here is another chart showing results from 1999 through 2000 of Berkshire Hathaway’s share performance vs. a buy-and-hold strategy of the S&P 500.
Over this 2-year time period Buffett’s stock price went down to 40% in early 2000. And during that same time the S&P 500 was up 13.49% in early 2000. That’s an underperformance of 53% using the S&P 500 as a benchmark!
What would the temptation be for the average investor holding shares of Berkshire Hathaway? To sell out of course.
But notice now how the charts look when we take the time period from 2001 through 2002. Berkshire Hathaway outperforms the S&P 500. Berkshire was up 8.42%, while the S&P 500 was down 30.42%.
The next question to ask yourself is, “What would have happened as an investor if I sold out of Berkshire stock in early 2000 after sustaining a 40% loss, only to buy into the outperforming S&P 500, which sustained an additional loss of 30.42% from 2001 through 2002?”
The question answers itself.
Does Buffett’s short-term market underperformance mean that his style of investing is not a smart way to invest? Of course not. He continues to stick to what he knows. He buys companies that he understands at low prices. These acquired companies must have some type of competitive advantage. And their business model needs to be simple enough a fool could run the company, because one day a fool may run the company. (I’m paraphrasing Buffet here.)
Empirical evidence of investors consistently underperforming the market
A company called DALBAR has been documenting for over 2 decades the phenomenon that investors consistently under perform the market. They release a report every year showing the under performance.
Over a 30 year period the average equity investor earned 3.79% vs. the S&P 500 earning 11.06%. Over the 12 month period (using 2014 results) the average equity investor earned 5.50% while the S&P 500 earned 13.69%.
These are significant underperformance figures, both for the short time frame of 12 months and the long time frame of 30 years.
This quote from DALBAR is very important:
“The underperformance results from bad investor decisions at critical points, the first in the face of severe market declines and the second when the equity market surged.”
In other words, a primary driver in investor underperformance is panic selling when markets have severe declines, and buying high after equity markets have already surged.
You would think that with all the information investors have available to them for free on the internet, one thing they could easily learn would be fundamental principles of investing. Namely, taking a long view of things. This is easier said than done.
The reality (and empirical evidence) do not bear this out. Investors should think long-term, but we all live in the short-term. And the short-term can cause the average investor to make decisions that hurt their portfolio.
Successful investors love it when you do this (by the way)
The panic selling and irrational exuberance of the average investor is a great benefit to successful, patient investors. Investing is a zero sum game. This means that if the market as a whole performs 10%, in order to “beat the market” a successful investor must make more than 10%. And the only way a successful investor can do that is if another investor under performs the market.
Warren Buffett is a master of this. He finds a good company that he feels is well run with a competitive advantage, and he waits until it declines in price. If investors panic and start selling a certain company, the price will go down. Other investors may follow suit and sell that company causing further losses.
Smart investors like Buffett will sit back and wait until the price of a good company gets low enough, then he buys it up for cheap. The other investors lost money when the price went down and they bailed out. He buys it cheap believing it will eventually go up in price because he believes it’s a good value. His gains are the other guys’ losses. Zero sum game.
That means successful investor love it when average investors panic sell. They love it when average investors jump into the market after it has already experienced large gains (and is poised for a correction).
What’s the solution to investing for retirement then?
This is where we get into more conventional knowledge that you may have heard before. But we are going to add to this the fact that we must recognize investor behavioral patterns. And then we must try to compensate for these investor behavioral problems that cause many investors to sabotage their portfolio and hence their retirement security.
One way to stay on the right path to help you have more success with your retirement investing is to minimize the scariest part of investing, which is losing money.
But the problem is that all investments involve risk, hence the common phrase you’ve probably heard plenty of times:
“All investments involve risk, and past performance does not guarantee future results or returns.”
One way to help reduce the risk of losing money in your portfolio is through diversification. I know that word sounds like a cliché, and you hear it all the time. But it really is the closest thing you can get to a free lunch when it comes to investing.
When it is done right you decrease your investment risk, and the odds of losing money are smaller when you get diversification right. Not only does it allow you to decrease your risk, but you can do so without decreasing your portfolio’s expected return.
That’s why it has been called the only free lunch in investing.
And it means all the stuff you’ve heard before, such as blending in different assets into your portfolio, like equities, mixed in with bonds, cash, and some alternative assets too.
And all of that is true, but there is another aspect to diversification that many investors overlook…
Just like some asset classes, such as equities, will have their day in the sun, the same can be said for investment styles.
As I mentioned above, Warren Buffett’s value style of investing did not have its “day in the sun” from 1999-2000. It’s a good investment philosophy, but like any style of money management, it won’t outperform the benchmark every year.
This means another layer of diversification that can be added to a portfolio to help reduce its risk is different investment styles. This may include mixing in some passive investing that tracks a broad index (like the S&P 500), along with growth style investing, value investing, small-cap investing, momentum investing, etc.
During different markets each strategy will perform differently. When one strategy does poorly, perhaps another strategy will help offset that performance. In other words, it’s using a second layer of diversification to help reduce risk and volatility in a portfolio.
The purpose of doing this is to help reduce the odds of losing money in a portfolio. The DALBAR study has shown with empirical evidence that the times of severe market declines are when investors make the worst decisions. If you can build a portfolio that acknowledges this behavioral tendency, and tries to reduce and mitigate these scary investing moments, that will help you stay committed to your investment strategy.
In other words, it helps the average investor set up an environment that helps them to succeed at investing. And investment success helps to lead to a stronger financial future and a more secure retirement.
If you are being advised to just diversify using asset classes (like equities, bonds, etc) and not also different investments strategies / styles of money management, then you are missing out on another layer of diversification. And investors need to be aware of that when they are seeking advice from financial planners before retirement.
Have questions about investing for retirement?
If you have questions please let me know. [You can securely reach me by email by clicking here.] You can also leave a comment below with a question too. I know that investing for retirement can be confusing. And it can be stressful when you are turning 59 ½ or even officially retiring and you want to make the right decisions about what to do with your 401(k), 403(b), TSP and other savings you’ve spend your whole accumulating.
If you know anyone that is facing this situation, please share this post with them. I know a lot of people are retiring every day and feel lost about what to do with their portfolio when they leave their employer’s sponsored retirement plan. My goal in writing this post is to provide objective information to help retirees make better decisions. When you share it, more people will be able to find it and hopefully benefit from it.