If you have done a lot of investing, or been in the market for a long time (for example, in a 401(k) plan), you have probably had some successes, and periods of time when it seemed like the stock market was a breeze. But if you have been in the market during the past few years, or even in the past few weeks, it’s likely you took a big hit. And while the stock market has actually recovered most of what it lost in the last two and a half years, chances are you personally have not.
Although it is possible for individual investors to do well in the market, more often than not, they don’t. There are at least three big reasons for this.
First, a large portion of your profits gets scooped off the top. A recent article in Forbes Magazine explained that if you invest in mutual funds (which is what most individual investors do, and where most 401(k) funds go), there are explicit fees, hidden fees, and other costs that can easily take 2½ percent or more of your account balance every year.
That may not sound like a lot, but when investment works well over a long period of time, it’s because the earnings compound. The longer you invest, the faster your balance grows, and the more that 2½ percent is worth. You might be surprised to know that if you started with $10,000 and it grew at 7 percent a year for 30 years, it would be worth $76,123 at the end of that time – but if 2½ percent went into expenses, so that your account was actually growing by only 4½ percent a year, the balance at the end of 30 years would be just $37,453. Slightly less than half! (And since you started with $10,000 in this example, the 30-year gain at 4½ percent is $27,453 versus $66,123, an even more glaring difference.)
Second, you’re an amateur playing against professionals. Is there any other field of human endeavor where people routinely compete against others with much greater training, experience, and focus, and actually expect to do well? Are you a better ball player than the Celtics, a better healer than the doctors at Mass General, a better writer than the authors under contract to Houghton Mifflin? Why should you be able to beat – or even come anywhere near matching – the portfolio managers at Fidelity, or the pension fund experts at John Hancock, or the private investment specialists at Loomis Sayles? Are you nuts?
Maybe you realized all along that you couldn’t play at their level, and that’s why you put your money into mutual funds. Basically, you were hiring them to work for you. But even apart from what that’s costing you in expenses as noted above (and just who’s working for whom here?), putting your money into a mutual fund is only half the battle. Another question is which mutual fund? Maybe you checked the Morningstar ratings, and if so, good for you, for trying. But Morningstar only knows which funds have done well in the past – they have no legitimate idea which funds will do well in the future. Meanwhile, the professionals do know a lot that you don’t know about which funds make sense at what times.
They have experience, which counts for a lot. They also have sophisticated mathematical models which indicate to them when, for instance, it might be good to back away from growth stocks and go into income stocks, or when stocks should be de-emphasized in favor of bonds, or when U.S. securities in general are maybe not looking as good as opportunities in Europe or Asia or elsewhere. They are playing the game at a whole different level from you – you with your mutual fund.
And that’s before we take into account that the financial industry has inside connections that you don’t have, influence with legislators and regulators who can tip the playing field in favor of the big boys, and sometimes the opportunity to play dirty in ways that the rest of us can’t even imagine.
So how, exactly, do you expect to keep up?
Third, research continues to show that most people are wired for failure in the financial markets. This goes back to our evolutionary roots. A danger signal would arise among our primitive ancestors, and the whole tribe instinctively rose up as one and skedaddled.
Yes, this is the “herd instinct,” but it still works in our favor at times. If thousands of people are suddenly running away from the World Trade Center, your smart bet is to run with them, rather than against them.
But this is not true when it comes to investment.
Again and again we see that when markets are going up, people who pay any attention to them at all start to get antsy. The markets go up some more, and we start hearing some of our friends brag about how much money they just made in a few months’ time. So more people buy in, and the markets keep going up. The more it goes up, the more people feel like they need to get in on it, and money is now pouring into the market, and so prices keep going up. You finally knuckle under. You buy.
Maybe your investments also do well – for a while. But then some people start to sell. Or maybe some outside event throws the market into doubt. Suddenly there are more sellers than buyers, and prices start to ease. But you are too smart to panic, and you don’t want to sell at a loss. Other people do get nervous, though, or decide they’ve made enough and don’t need to be greedy, so more selling occurs. Now the market is starting to drop a little faster. You try to hold on. More people get nervous, and more people sell. Your paper losses get bigger, and you hate to give in. But before you know it, there is panic selling, and the market crashes. You throw in the towel and sell.
There is a well-known Wall Street saying that to make money all you have to do is buy low and sell high. But what did you do? You bought high and sold low. You followed the herd, and like the herd, you got slaughtered.
The way to make real money in the markets is to go against the herd. To buy low, you have to buy when everyone else is panicking – in the phrase of Baron Nathan Rothschild, one of the most successful investors of all time, “when the streets are running with blood.” And then sell when everyone else is full of blind confidence.
But how many of us have the nerve to do that?
So why do you lose at the investment game? Your best profits are being skimmed away by fund managers, you are bringing amateur skills to a professional contest, and your most powerful instincts mean you are hard-wired for failure.
Maybe you should be doing something different with what you’ve got.
Chuck Yanikoski is a retirement adviser who lives and works in Harvard. For more about him, visit http://www.ChuckYRetirement.com.