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Why most investors under-perform the market

October 28, 2010 Leave a comment

According to the most recent study from independent consultant Dalbar, Inc. the average investor earns slightly more than 3% per year on the money they have invested in the stock market.  To put it bluntly, that’s awful.  Especially when you stop to consider that the market return is about 8.5% per year.  It begs the question, why does the average investor do so much worse than the stock market as a whole?

The answer lies in the fact that investors do a very poor job of timing when they get into and out of the stock market.  Typically, investors buy stocks and mutual funds through their company retirement plan, and as long as the economy and the stock market are chugging along, they’re happy.  During these long periods of stability, the stock market usually produces annual gains of around 10%, and the average investor participates in all of those gains by staying invested and adding a little more each month.  But inevitably things start to deteriorate when the economy starts to slip.

As the economy slows, which is as natural as the ebb and flow of the ocean tides, the stock market starts to go down.  The decline is usually slow at first, but it tends to accelerate as more evidence piles up about the weakening economy.  At the worst possible time, when the stock market has declined by 10%… 20%… or more, the average investor finally reaches his or her limit of pain and decides to do something about it.  It’s at that point where they sell their stocks and sit on the sidelines… determined to wait until things  get better.

As it turns out, this is exactly the worst possible way to manage your investments.  By waiting for the stock market to be down so much that you just can’t take any more pain, you’re probably selling at or near the bottom of the stock market cycle.  But wait… it gets worse.

After selling their stocks near the bottom of the market cycle, the average investor now faces the next challenge… when to get back in.  What happens next is that the economy begins to recover, and the stock market begins to rise again, but the investor is still upset about all the money he lost in the decline.  So he waits to see if the market miight go down again before he gets back in.  But of course, the market does not cooperate with this strategy, and it instead plows ahead to make new high prices.

Finally, in total frustration and regret, our investor throws in the towel and gets back into the market.  But because he waited so long, he has to pay a much higher price to buy back his stocks, than he got for them when he sold them near the bottom of the cycle.  So he’s now completed the process of selling low, and buying high.  That’s exactly the opposite of what he should have done.  And that’s why he only earns about 3% per year instead of 8.5% that the market is offering.

So how can you avoid falling into this vicious cycle?  By hiring a reputable investing coach and learning how to manage your investments proactively, rather than reacting to the pain of losing money all the time.  A good coach can tell you the signs to look for that will tip you off that there is trouble ahead, and what you can do about it.  A coach can keep you from shooting yourself in the foot by selling low and buying high.  A good coach is worth his weight in gold.