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Finance: Investors Out-Psyche Themselves

Sun, Aug 3, 2003 03:18 PM (Linda Stern is a freelance writer who covers personal finance issues for Reuters. Any opinions in the column are solely those of Ms. Stern. You can e-mail her at lindastern(at)aol.com.) By Linda Stern

WASHINGTON (Reuters) - Individual investors have gotten so good at buying high and selling low that they've lost almost all of the stock returns that were out there, just by trading too much, according to a new study.

The average stock mutual fund investor earned a paltry 2.57 percent a year over the last 19 years, a period when the Standard and Poor's 500 stock index returned 12.22 percent a year, according to the report published by Dalbar, a Boston research firm.

Investors didn't even beat the inflation rate of 3.14 percent that occurred during that period. Bond market investors did only a little bit better, earning 4.24 percent annually compared to the 11.7 percent returned by long-term government bonds.

Why? Because investors have not been able to tame their emotions when it comes to the market. They continue to put money into stocks when share prices are rising and pull it out when they are falling.

Theoretically, that's a good practice, as long as you catch both moves early in their cycles. But since most investors cannot really predict when these big moves will occur, they wait for confirmation. By then, it's too late and again, they have done the buy-high-sell-low two-step.

The study looked at cash flows in and out of the market and correlated them with up and down moves in prices. There was no correlation, the researchers found, in news events. For example, it wasn't the terror attacks of Sept. 11, 2001, that caused mutual fund investors to sell, it was subsequent declines in share prices and selling by others. Put simply, it's the worst of pack mentality.

Dalbar's research often is used to support the notion that investors who buy their stocks, bonds and funds through advisers do better. That's not necessarily because advisers do a better job of picking investments, but because they may talk their clients out of following the market just because they are feeling afraid or greedy.

But there are ways to talk yourself out of these emotions. Here are some techniques to improve your investment returns. You still may not beat the market, but at least you will do better than your moody co-investors.

-- Buy the overall market and stay in it. Do that by buying a low-cost index fund for the core of your portfolio. Instead of timing your purchases and sales for what's happening in the market, time it for what's going on in your life. If you are building toward retirement, keep investing and don't sell during bad times. If you do sell, there's a good chance you'll not get back in before the rebound comes. And that's when you make your money.

-- Try being a little contrarian around the edges. If the market seems to be spiraling downward, don't sell, buy. Maybe it will move down even more, but you'll know you aren't buying at the top. Hold your shares long enough, and as they recover, you'll recover faster. Similarly, if prices have been going up, up, up (remember those days?) don't assume they always will. Do as the pros do and lock in some profits by selling when prices are high.

-- Use dollar cost averaging. Direct your bank to send money to your favorite fund every month and invest it fully. This takes crazy emotions out of investing and locks in a system that guarantees you more shares at lower prices. You won't miss the monthly withdrawals from your checking account or paycheck, and the longer you just let this happen without worrying about it, the higher the sums you'll build.

-- Take this opportunity to learn a lesson. Record-low interest rates mean bond prices are higher than they have been in a very long time.

Sure, they could continue to rise. It's more likely that new buyers who are following what's been a fabulous market for three years running are once again going to get bloodied by their emotions.

(Linda Stern is a freelance writer who covers personal finance issues for Reuters. Any opinions in the column are solely those of Ms. Stern. You can e-mail her at lindastern(at)aol.com.)

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