Alright, about that gap we talked about last time. The gap between what the stock market returns, on average, as compared to the real returns that investors actually experience in their portfolios. Here’s an illustration to give it some more context.
Starting at the left hash, imagine we’re just coming off a market downturn so Bob (let’s call our investor Bob) is still feeling nervous about the market. At this point he still doesn’t know which way it’s going to go. Then, as the market moves toward point A, Bob starts feeling more confident. Things seem to be improving and he’s thinking, "Yeah, I’m ready to invest again." So at point A he decides to invest by purchasing some mutual funds. The market continues to climb and Bob’s feeling good.
Then, after a while, things turn the other way. The market slowly loses speed. Then the market just seems like it’s not going anywhere but down. As the market approaches point B, Bob just can’t take it anymore. He decides to sell the mutual funds he bought at point A to preserve what’s left of them.
And with that, he just made the most fundamental investing mistake ever… he bought high and sold low. It’s easy to laugh at the prospect of buying high and selling low, thinking, "I would never do that." However, as you walk through the scenario above, I think you can appreciate how easy it can be to make that mistake, especially when you factor in human emotions.
Bob waited to get into the market until things were going good and he felt confident about the future of the market and then the market went down and down and down and Bob just couldn’t psychologically handle seeing his account balances continue to suffer,so he got out.
To avoid this human tendency to buy high and sell low, we must have the proper asset allocation and we must also recognize that, beyond the right hash in the graphic above, the market always comes back. It always recovers. Maybe not on the timeframe or to the extent we’d prefer, but it always recovers and we must stay invested in order to get those returns.
Next musing I’ll explain asset allocation and how it can help you stay in the market and avoid the human tendency to buy high and sell low.