Are you an Average Investor?

Are you an “Average Investor”.  Before going any farther, it is important to note being an Average Investor is not good.  The reason is many long term studies show the average investor under perform market averages.  

Why does the average investor underperform?  Again, there have been a number of studies on this.  Reasons include, being emotional, herd mentality, lack of knowledge or assuming knowledge in one field translates to financial knowledge [fyi, it does not], inexperience [keep in mind, one year of experience repeated for 30 years is still inexperience], and poor financial advice to name a few.  

I would suggest one primary reason for under performance of the average investor is simply not understanding how to determine return on their investments.  Many investors review their quarterly or annual performance report and if they see negative numbers, they believe they are losing money.  Conversely, if they see positive numbers, many investors believe they are making money.  Neither is true.  The only time an investor makes or loses money on an investment is when the investment is sold.  Period. 

Though understandable from an emotional perspective, there is a reason why most every disclosure says something like “past performance does not predict future results”.  The market value and subsequent year to date gain or loss, only tells an investor the value of the investment and return as of day the report was run.  Any given day or time period for that matter, a wide number of factors go into the closing market value of any equity investment, some short-term and are not related to long term fundamentals.  Sometimes the market value of holding can be relatively consistent for an extended period of time.  At other times, it can change dramatically, up or down, in a short amount of time. 

Average investors often look at negative return on a performance report, make an emotional or uneducated decision to sell it and lock in loss.  If the investment increases in market value in the future, it is too late for the average investor. 

So, if in my estimation performance reports are of no value in making investment decisions, what is of value?  Before even looking at any Report, I would suggest the following:

  1. One, understand what you own or are buying.  Also, have a reasonable understand of the risk/reward ratio and expected return for each holding in the Portfolio and the Portfolio overall.  

  2. Have a stated time horizon for holding.  For equities, I would suggest a minimum of a five-year holding period.  

  3. Have a return objective your time period.

  4. Make a decision on volatility when you make the investment, not when you look at a performance report.  If you look at a statement and there is a decline, are you going to panic and sell turning a paper loss into a real one.  Again, the only time you make or lose money on an investment is when it is sold.  

In short, if your time horizon is five years, why would it make sense to sell one year if there is a decline, especially if the decline is within the stated risk/reward ratio.  The reality is, it does not make sense. 

So how do you avoid being an “average” investor going forward.  Commit to the understanding the only time you make or lose money on any investment is when you sell it.  A performance report simply tells you the valuation at the time of the report, nothing more.  It does not tell you what you will be able to sell a holding for in the future.  When you review your portfolio, compare your cost basis to current market value and if you have not reached your long-term objectives, make a decision based on long-term fundamentals, not on recent performance. 

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.