Investing 101

The Main Reason Investors Fall Short

Over the past several decades, investors have suffered from a curse.

And that curse is one of mediocrity.

Wall Street likes to say, “Nobody can beat the market.”

And the sobering reality is that the little guy’s performance often backs that up.

According to Dalbar’s 2021 midyear Quantitative Analysis of Investor Behavior study, Jane and Joe Main Street struggle to keep up with the major indexes.

In fact, the average investor underperforms the S&P 500 Index by a wide margin…

Investor Performance Over Time

In 2020, retail investors took advantage of the volatility and closed some of that gap.

But in the first six months of 2021, the average investor’s portfolio slipped and trailed the broader market by 2.1 percentage points.

The problem is the average investor keeps stepping up to the plate and swinging… but the results keep coming up short.

And here’s the truly frustrating part…

It’s not because the markets are rigged.

It’s not because fees or taxes are too high.

And it’s not because there’s a lack of valuable information to profit from.

The reasons for the shortfalls tend to be investors themselves.

The Sour Taste of Humble Pie

We’re going to tackle this issue like Paul Hollywood slicing into a home baker’s raised game pie on The Great British Baking Show – which means we’re going to cut it into three giant pieces (and be wary of any “soggy bottoms”).

The average investor’s underperformance boils down to three simple causes.

Reasons for Investor Shortfalls

Let’s talk about the two smallest bits first.

Not having enough capital to invest makes up a quarter of the average investor’s underperformance.

More times than I care to count, I’ve heard people say, “I don’t have money to invest.”

And that’s not true. You do. You can take advantage of your company’s 401(k), you can open a trading account and you can contribute to an IRA.

We all start small.

That’s why I always stress saving, living below your means, not worrying about what the Joneses are doing, working to pay down debt and not relying on margin!

The capital will eventually be there.

Next, we can see that another 25% of the shortfall is because capital is needed for other purposes.

And that’s fair.

My main piece of advice for investors is this: If you’ll need the money you’re planning to invest in the next 12 months… don’t invest it.

Besides general market risk, there are transaction fees and short-term capital gains taxes that are going to eat away at your returns.

But looking back at the chart above, we see that the biggest reasons average investors can’t beat the market are psychological factors.

My Own Worst Enemy

“It’s no surprise to me, I am my own worst enemy.”

Now, that’s likely the only time I’ll quote the band Lit. But I couldn’t think of truer words for talking about the pitfalls of investing.

Psychological factors account for half of why the average investor underperforms.

And here, we see these same biases and unhealthy habits repeated over and over and over again.

These are silly – but costly – missteps, like loss aversion. Our brains are hardwired to avoid losses. So we tend to take gains too quickly and hold on to losers for far too long.

Studies have shown that we feel something akin to physical pain whenever we lose money. In turn, investors tend to do everything they can to avoid it.

This is why we recommend trailing stops. They’re emotionless, mechanical and robotic.

Herd mentality is another big contributor to lackluster results. I rail against this often. It’s “panic-selling” and “chasing” a stock higher. Those are the hallmarks of the highly ineffective “buy high, sell low” strategy that investors can easily fall into.

No matter how often Warren Buffett or anyone else says to buy low and sell high, so many people tend to do the exact opposite.

These two missteps are the main psychological reasons investors underperform the market.

And they are the main drivers behind the investor psychology cycle

Investor Psychology Cycle

All the damage that average investors do to themselves is right there.

Pin the chart on your wall.

We’re about to head into third quarter earnings season. Now, I’ve outlined how October tends to be a great month for stocks. But that doesn’t mean it’ll be free of volatility. And there will likely be days ahead that test your mettle.

You can hum Lit’s “My Own Worst Enemy” to yourself or peek over at this chart to make sure you’re not guilty of any of these portfolio-damaging sins.

Here’s to high returns,

Matthew

P.S. Have you ever received golden investing advice that has saved your portfolio? Let us know in the comments below.

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