According to one old adage, making money in stocks is simple: Just buy low and sell high. Unfortunately, most people do the exact opposite -- buy high and sell low -- and pay dearly for it.
Investment research firm Morningstar has spent the past several years looking at both the reported returns that mutual funds generate and the actual returns that typical investors earn in their accounts. At first glance, you'd think those numbers should be the same. But because investors can add or withdraw money from mutual-fund accounts at any time, their timing on buying or selling fund shares factors heavily into how much total profit they earn.
The results of Morningstar's research were surprisingly negative for investors. Over the past 10 years, investor returns have lagged behind fund returns for every single one of the asset classes that Morningstar looked at:
For U.S. stocks, the difference in average annual return was more than a full percentage point, which equates to a difference of $2,000 in lost returns on an initial investment of $10,000.
The disparity for international stocks was much worse, with a 3-percentage-point annual difference resulting in total underperformance of $6,500 on a $10,000 initial investment.
Why Investors Miss Out
These differences reveal just how big a role emotion plays in investing.
When the stock market is in the middle of a big bull-market rally, as it has been for the past four years, investors get increasingly greedy and look jealously at the past returns that stocks have produced recently -- perhaps gains that they missed because they sat on the sidelines waiting for the waves to get less choppy.
As a result, they tend to pile in after those high returns have already happened. We've seen that phenomenon again recently; with stocks approaching record highs, purchases of mutual funds in January hit a record of more than $80 billion, with nearly half of that going into stock funds.
Meanwhile, when the stock market falls, Morningstar notes that fear and anger replace greed and jealousy. Those emotions drive investors to sell off their investments even after they've already lost huge portions of their value, locking in permanent losses that become next to impossible to recover from.
3 Keys to Rule Your Emotions
It's tough not to let your emotions influence your investing decisions. But there are some steps you can take to minimize their impact and keep you from losing money in the long run.
1. Make investing a regular habit rather than a knee-jerk response to changing market conditions. If you set up automatic purchases to invest a certain fixed amount of money on a regular basis, regardless of whether the stock market is up or down, then you won't need to pay as much attention to fluctuations in the markets. Moreover, because of the benefits of dollar-cost averaging, your investment will buy more shares when the price is low and fewer shares when prices rise, giving you more benefit from any temporary bargains that come along.
2. Have a long-term investing plan that includes specific goals. If the only number you focus on is your current balance in your brokerage account, then you'll pay far too much attention as that number inevitably moves up and down day after day. But with concrete goals -- preferably with intermediate targets along the way -- you'll keep perspective on how close you are to achieving them and spend less time obsessing over daily fluctuations.
3. Use your past experience as a guide to how you're likely to respond to future market moves. If you've panicked in the past when the market dropped, then you should adjust your strategy to reflect your lower tolerance for risk and volatility. But if you have a good history of being able to buy stocks during market crashes, then you've already demonstrated your ability to master your emotions to make profitable investing decisions.
Buying low and selling high is harder than it sounds. If you can keep emotions out of your investing picture, though, you'll have taken a big step toward being a successful investor.
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