We’re hardwired to be terrible investors – here’s how to get around that

Investors - disappointed stock trader © Getty Images
Most investors are terrible at making money.

Few things mess with our heads like money.

We hate losing it. And when we make it, we don’t feel happy.

If our profits are paper ones, we fret about losing them. And if we sell out and take our profits, we spend all our time regretting the ‘loss’ of anything extra that could have been made if we’d hung on for a bit longer.

In short, we are hardwired to be appalling investors.

But you might be surprised to realise just how appalling.

Most investors are simply terrible at investing

John Authers picks over the Quantitative Analysis of Investor Behaviour report by US researcher Dalbar in his latest FT column. It makes for fascinating and somewhat depressing reading. To cut a long story short, it proves yet again that investors are our own worst enemies.

Basically, the report compares the return that the market makes, with the return made by actual investors. The results are, frankly, shocking.

The S&P 500 (this is a US study) returned 11.6% a year over the past 30 years. That’s an excellent return – way ahead of inflation over the same time. So how much do you think investors made?

If you’d asked me to take a punt at the answer, I’d have said 6%. That’s pretty awful compared to the market. But after all, lots of investors use active funds, which often underperform the market. And lots of investors use overly-expensive advisers or vehicles to invest, which hurts their returns too. And they’re also prone to buying and selling at exactly the wrong time.

But 6% is positively genius compared with the actual figure. Your typical investor only made 3.79% a year. That’s barely ahead of inflation. And obviously it’s an awful lot less than 11.6%.

Costs and poor active management contribute to this. But, says Authers, “the overwhelming driver is bad timing by investors.” People sell at the wrong time. Or they buy in, the market goes down, they regret their decision and they reverse it, rather than hanging in there.

Of course, a lot of this is self-fulfilling. Someone has to panic and sell at the bottom, after all. If they didn’t, there wouldn’t be crashes.

But it’s quite worrying really. We tend to be over-optimistic when we forecast our future returns. If you look at the average numbers the industry uses to predict your pension fund’s growth for example, then you’ll find they’re a lot higher than 3-4% a year.

At the same time, it’s quite heartening. Because it means you don’t need to do much to be better at investing than the average investor. You just need to find a way to keep your head when all about you are losing theirs.

Big question is – how do you do that?

How to short-circuit your emotional reaction to money

The key is to try to ‘automate’ as much of your investment process as possible, and bypass your own instincts where you can.

I’ve talked about this a lot in the past, but your core strategy should involve coming up with a suitable asset allocation. In other words, you divide your money into pots, putting a certain percentage into bonds, equities, gold, cash etc.

You then decide on the best way to invest in each theme. Cheap tracker and exchange-traded funds should be your first port of call. Save into these funds regularly, and set up a quarterly or half-yearly date to review your asset allocation.

If it gets too far out of whack with your asset allocation percentages, you adjust by selling the assets you own too much of, and buying those you don’t own enough of. That way you ‘sell high’ and ‘buy low’ automatically.

If there’s a crash, you don’t panic. Because you’ll be buying as stuff gets cheaper. And you don’t fret about whether the market is getting too high or not, because you’re selling when it gets more expensive.

This really matters. You’re removing your emotions from the market timing process – and that’s the thing that really destroys most people’s returns.

Being contrarian pays

Of course, if you’re a more active investor, you can also profit handsomely from other people’s investment psychology. As Authers notes: “mass poor decision-making virtually guarantees that there will always be someone on the other side of the trade when a fund tries to buy when others are fearful and sell when others are greedy.”

In other words, being contrarian should pay off, because you’re the one buying while everyone else is running away. My colleague Tim Price is particularly interested in contrarian and value investing. If you want to find out more, Tim’s put together a very special package right now that sold out within eight days the last time we did it – check it out now if you missed it last time.

Oh and I strongly suggest you check out Merryn’s latest video interview with Tim, if you haven’t already – it’s only just gone up on the site.

• This article is taken from our free daily investment email, Money Morning. Sign up to Money Morning here.