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Investing Pitfalls

May 11, 2022
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Unlike 2021, volatility is certainly up in 2022. I’ve had a few recent requests from clients regarding when to invest, or the desire to move their investment to cash if their account fell to a certain value. This, essentially, boils down to market timing or investing on emotions, and neither is a good strategy.

Common Investor Pitfalls

The average investor has a poor track record when it comes to investing. This is largely attributed to investors making decisions based on emotion rather than fundamental data. There have been studies that have quantified this poor performance. Probably the most well known comes from Dalbar.

Based on their data, which looks over a 20-year period, from 2001 – 2020, the S&P 500 earned an annualized return of 7.5%. Now, for someone who had a 60/40 asset mix of stocks to bonds, that return was 6.4%. Those are not bad returns for a 20-year period that included 9/11, the Great Recession and a pandemic. Unfortunately, though, the average investor’s annualized rate of return was only 2.9%.

For comparison, inflation averaged 2.1% over this same period, so the average investor was barely maintaining purchasing power. Data like this shows that the average individual is poor at investing their money.

Heightened Volatility Can Create Uneasiness and Anxiety

Outside of asset allocation, contribution or withdrawal rates, we cannot control the day-to-day movements of the markets. Also, when we discuss market risk we tend to think just about the stock market. But as we’ve seen this year, bonds, while somewhat rare, can also experience poor performance.

When investors come up against powerful emotions tied to losses in their accounts, they often hit a point of capitulation. They want losses to stop and decide to “stop the bleeding” by going to cash, with the idea of getting back in the market when things settle down or at least when the markets aren’t so volatile. The initial decision to go to cash actually creates another challenge; that is, when to get back into the market. This rarely works out, hence, the reason the average investor dramatically underperforms.

The biggest reason for this is that investors missed some of the best performing days while sitting in cash and waiting for the right time to go back in. JP Morgan put out a piece on this phenomenon. Their study, from January 1, 2002 to December 31, 2021, showed seven of the best 10 market days over that 20-year period occurred within two weeks of the 10 worst market days. They cited in 2020, that March 12th was the second-worst day of the year, but it was immediately followed by the second-best day of the year. This isn’t unique, as six of the seven best days occurred the day after one of the worst days.

So what does missing out on the best days really mean to an investor? Actually, it’s quite a bit. Someone who invested $10,000 in the S&P 500 and stayed fully invested from January 1, 2002 to the end of last year would have experienced a 9.52% annual return. They would also have seen their account value grow to over $60,000.

For example, an investor that missed just the 10 best days over that 20-year period would have seen their account value cut by more than half to $28,260. That’s an annual return of 5.33%. That’s a lot of money for just missing 10 days. Missing the 20 best days cuts the annual return in half to 2.63%, and from there, it is more painful than the more good days that are missed.

This shows that while making modifications or adjustments are certainly warranted from time to time, jumping out and back in doesn’t consistently work.

Recency Bias

As an investor, another pitfall to avoid is recency bias. Recency bias is exactly what its name indicates. It is putting more emphasis on the recent past. Basically, it is human nature to favor current events over historical ones when thinking about what lies ahead. This is something that has probably always been true.

If you look at recent investments into growth stocks, you see how investors have looked at the recent returns in this sector and either added after these securities had gone up or sold after they had already dropped. Essentially, they’re buying high and selling low, which is the exact opposite one would want to do.

So, the takeaways from all of this is, in a year that we have experienced – and will likely continue to experience – high market volatility, it is unwise to make investment decisions based on emotions. History has shown that neither going to cash nor chasing returns has translated into better returns. If fact, it has been detrimental to investors. It can harm the success of their long-term plans, and that is never a desired outcome in my years of experience.

DISCLAIMER: Past performance does not predict future results. This report is based on data obtained from sources we believe to be reliable. Baird does not, nor any other party, guarantee the accuracy or completeness of this report or make any warranties regarding results obtained from its usage. All opinions and estimates included in this report constitute the firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation to buy or sell the securities herein mentioned.