Don't get me wrong. I'm not saying investors are stupid. I'm saying they follow the advice of people who pay no attention to the data. As a consequence, they engage in "stupid investor tricks."
Here are some examples:
1. Relying on pundits--not data--to "explain" the significance of current volatility. Neither is predictive, but at least the data is accurate. Historically, volatility has meant poor returns. But over the past 82 years, periods of negative returns (six months or longer) have been followed by periods of positive returns, on average.
2. Using volatility as an opportunity to pick stocks or time the market. You would think these strategies would work better in times of high volatility, but consider this: Do you really believe you (or your broker) know more about the markets that the collective wisdom of the millions of investors looking at the same data? Remember, if you are buying, they must be selling. One of you is going to be wrong. Do you regard a 50/50 chance as good odds?
3. Overreacting to current market conditions. Over the past three years, ending September 30, 2008, it would be extremely difficult to find any asset class of equities, domestic or international, or any bond index fund, that did not report positive returns. If your time horizon is less than 5 years, you should not have any exposure to the stock market. In times like these, it's important to keep long term returns in mind to give yourself some perspective and avoid panic.
4. Using the S&P 500 as a proxy for "the markets." The ten year returns of the S&P 500 have been dismal--less than 3%. This has lead to many misleading articles about "the lost decade." But the S&P 500 is not a proxy for the global equity markets, which is why investors should have a globally diversified portfolio of low cost index funds for the stock portion of their investments. The annualized return of this portfolio over the same period was in excess of 7.50% (through September 30, 2008).
5. Engaging in active management. According to a recent study by Kenneth R. French, for the twenty-six year period from 1980-2006, if a representative investor switched from an active to a passive market portfolio, he would have increased his average annual return by 0.67%. We are talking serious money here. No great skill is involved, yet over 90% of all individual investors flush this money down the toilet every year.
6. Buying hedge funds.. Professor French found that the typical hedge fund investor did not break even in 2007 unless his U.S. equity-related hedge fund generated an average abnormal return of 6.48%. "Abnormal returns" means the hedge fund had to exceed the market returns by that percentage. That is like running the 100 yard dash with a 50 pound weight on your back.
These troubled times demand that beleaguered investors teach themselves new tricks.
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