Your Money_ The Missing Manual - J. D. Roth [130]
Here's a specific example: During the 20-year period ending in 2008, the S&P 500 index returned an average of 8.35%, but the average person who invested in stock-market mutual funds only earned 1.87%, which puts him behind even the rate of inflation (2.89%). In other words, the average investor has underperformed the market by nearly 6.5% over the past 20 years. This "behavior gap"—the difference between overall market returns and individual investors' returns—is devastating to any hope of long-term financial success.
Tip
For more about the gap between investor returns and investment returns, visit BehaviorGap.com, where you can download "The Behavior Gap: A Snapshot" (www.behaviorgap.com/the-lab/), which takes a closer look at this phenomenon.
Why do investors underperform the market? Part of the problem is that so many of the mutual funds out there are actively managed. When you pay somebody else to manage your money in one of those funds, you're giving up 1–2% of your return right from the start.
Psychology and emotions play a huge role, too. Investors tend to be overconfident—they think they know more than everyone else. But according to the 2009 edition of Dalbar Inc.'s study, investors only make the best choice 42% of the time, meaning they're wrong more often than they're right.
Though it can be tough, the best thing you can do to improve your odds of long-term investment success is to admit that you're not likely to beat the market. Your best bet is to try to match the market, and you'll learn ways to do that on Common-Sense Investing. But first, let's look at how to overcome common behavioral barriers that cost the typical investor 6.5% per year.
Note
A study published in the February 2001 issue of The Quarterly Journal of Economics (http://tinyurl.com/PDF-gender) found that men trade 45% more often than women—leading to annual returns 1.4% lower. (And single men are even worse, earning annual returns 2.3% less than single women.) The reason? Overconfidence.
Know Your Goals
As you learned in Chapter 2, goals are an important part of your financial life, and investing is no exception. One way to reduce mistakes is to invest with a purpose. If you know why you're investing and have a long-term plan, it's easier to avoid making rash decisions that can lower your returns.
Financial advisers suggest you create an investment policy statement, or IPS, which is simply your target asset allocation (see the Note below) and instructions to yourself for how to set and maintain it.
Note
Asset allocation is the way your money is divided among your different investments; it's just a fancy way of saying "the things you've invested in." The classic example is the basic 60/40 split: 60% invested in stocks and 40% in bonds. To learn more about asset allocation, read the SEC's "Beginner's Guide to Asset Allocation" at http://tinyurl.com/SEC-assets. You can learn more here: http://tinyurl.com/GRS-alloc.
In other words, your IPS is a blueprint for your investments. It's a plan to help you build your future. An IPS helps you stay on course instead of trying to take shortcuts (by doing things like chasing hot stocks) or panicking when things fall apart (like during 2008's market crash). By keeping your goals in mind, you can avoid making financial mistakes.
It's easy enough to draft your own investment policy statement. A good place to start is Morningstar's step-by-step guide to creating an IPS (http://tinyurl.com/mstar-ips), which includes a free downloadable worksheet to get you started. If you want help and can afford it, pay a fee-only financial planner to help you develop an IPS. ("Fee-only" means you pay the planner directly and she doesn't get commissions for selling you stuff. For more on hiring a financial planner, see How to open a Roth IRA account.)