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Why Most Investors Underperform The Market |
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Written by Value Seeker
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Tuesday, 20 November 2007 |
It is farily well-known that over long periods of time, the stock market goes up about 10% a year on average. However, the vast majority of investors make far less than 10% a year on average.
If someone who simply parked all of their money into a broad market index fund could make about 10% a year, why is it that so few investors do this or are able to mimic the results?
There are two reasons most investors lose substantially to the market. Either the investor is not knowledgeable enough about the market to even understand the basics like index funds or the investor is overconfident.
First, let’s talk about the casual investor who simply knows very little about the market. Investors like these generally invest in mutual funds. The mutual funds they invest in are generally suggested by someone that works in their bank or are offered by their employer’s retirement plan. Often, these mutual funds are absolutely horrible and charge significant fees.
Since this type of investor does not know much about the market, he or she likely is unaware of the fees being charged and is also unaware that most mutual funds lose significantly to the market over the long run (this is because of both fees and the difficulty of most mutual funds to invest a large asset base). Most of these types of investors are the types that are happy if they make 7% during a certain year, even if the market makes 15% that year and are unhappy if they lose 5% a year, even if the market dropped 12%.
The ‘uninformed’ type investor should probably just park his money in index funds. While they won’t beat the market, they will not lose to it either. Most ‘uninformed’ types generally do not have the time or knowledge to try to actively beat the market. If they ended up doing most of the investing work themselves, they’ll probably end up in our second group: overconfident investors.
The second group of investors that consistently lose to the market are the overconfident types. These investors have a basic knowledge of the market but believe they can do better than just investing in index funds or broad ETFs. Most of the time, they lose significantly to the market.
When it comes down to it, this group of investors generally think they know what they’re doing, but don’t. There is no rosy way to say it; if they truly know what they are doing, they would beat the market. But since they don’t, they lose over time. Most of their mistakes fall into several years: excessive trading fees, trades based on emotions, and lack of knowledge.
Since the overconfident type of investor is managing his own money, he will need to make his own trades. In of itself, a trade is not necessarily harmful to your financial health. A trade generally costs $8-$10, which isn’t really a big deal. However, if you only have $50,000 to invest and you make about 10 trades a week at $10/trade, all of the sudden you are spending $100/week or $5,000 a year! The trades themselves are costing the investor about 10% of his asset base, and there’s pretty much no way the investor is beating the market by more than 10% (meaning, he’d be making 20% or more if the market is making 10%).
Stock trading is a rich man’s game. There are dozens of stock seminars, books, etc. geared for the average guy that teach trading. This is just plain wrong. It is almost impossible for someone with an asset base of less than $1 million to beat the market by much by constantly trading, simply because of the trading fees.
Furthermore, when you hold a stock for less than a year, you have to pay ordinary income on the earnings, instead of the lower capital gains. So even if you beat the market by about 1-2% after fees, you are still losing to it after taxes. So unless you beat the market by quite a lot (3% or more generally) or are trading in a retirement account, the fees and taxes alone will dwarf any advantage you get from trading.
The second reason overconfident investors lose to the market is their emotions, specifically fear and greed. When a certain stock, stock sector, or even the market is doing is looking ‘hot,’ they start to buy more. This is a recipe for buying at the top of a bubble. A lot of people invested in tech stocks in 1999 because they saw all of their friends and co-workers making money by investing in those stocks. We all know what happened to these people in 2000-2002.
Just as greed can cause poor investment decisions, fear can as well. As a stock or the stock market in general goes down, people’s inclination is to sell their holdings, even though this may present a buying opportunity if the market is oversold and undervalued. Between fear and greed, most overconfident investors end up buying high and selling low.
The final reason overconfident investors lose to the market is that they simply don’t know what they’re doing. In of itself, buying a random stock isn’t that bad. Technically, a monkey randomly choosing 50 stocks has just a good chance at overperforming the market as he does underperforming the market. However, when you combine this lack of insight with constant trading, it just results in a lot of fees with not much to show for it.
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