Why Do Individual Investors Do Worse than the Funds They Invest In?

October 22, 2010

So…when I wrote Part I of this blog, I pointed out an issue but gave no solution.  I hate it when people do that!  So, I’ll try not to do that very often.  The situation was that individual investors often make decisions that allow them to “Buy High, Sell Low.”  Now maybe I’m not the best with investing, but that sounds like a lousy strategy!  What can be done to improve it?

Well, the most obvious and simple answer (which surprisingly is often the best answer) is to have a strategy.  In conversations with thousands of people over the course of years, I have found that very few have an actual investment philosophy.  Even fewer have an investment strategy (a philosophy that gets put into action).  And even fewer have that strategy documented in a written format, discuss it with their investment advisors, and adhere to it during good and bad times.  In virtually every business book that I have ever read, one of the key “to do” items is commit any and all goals to paper.  If investing according to a strategy and not being emotional with your investment decisions is a goal, this is a great area to have written goals and strategies.

Some examples of things I have seen in written form or that I have heard from individuals to help them remove emotions from investment decision making (in descending order of effort) are:

  1. Have a written “Investment Policy Statement” that outlines your overall asset allocation, investment vehicles, buy and sell strategies, liquidity and tax concerns.   Here is some quick info and a sample.
  2. Before buying any investment, understand when you will sell it – both in good times (How much profit is enough?)  and bad (When do I sell this dog of a stock?).  When you know your exit strategy, buying or selling an investment becomes much less of an emotional choice.  Write down your “sell side strategy.”  Then….adhere to it!
  3. Use an investment risk profile form quarterly, semi-annually, or annually to review your investment risk and adjust your holdings accordingly.
  4. Use an automatic rebalancing feature through your financial advisor, 401(k) plan, or other financial provider.

Using any (or all) of these simple strategies can bring a level of order and process to your investment world, and help remove some of the emotions that often hurt investment performance.