Investing to Beat the Average

I WILL stick to the investment plan when things are calm, and especially when I’m feeling anything but calm. When my emotions are running high, it is the wrong time to make rational decisions, including rethinking my investment objectives.

Think about the last financial decision that you made – whether that be a major purchase like a home or vehicle, booked a vacation or simply bought a new wardrobe. How much time did you spend researching that decision, and how excited were you to get a discount?

For example, the last purchase you made was at the local grocery store. As luck would have it, Quality Foods was having a daily deal and bacon was 20% off!

A rational consumer would likely take advantage of the deal and maybe even buy a second or third. The furthest thing on their mind would be to rush home and throw a yard sale for all the meat in their freezer out of concern that prices may go even lower.

When it comes to tangible assets, it is much easier to recognize true value. However, we tend to treat financial assets much differently. It probably didn’t feel great the last time you opened your account statement to see your portfolio lower, even by 10%. Were financial assets on sale, or was it time to sell what you currently own?

With reference to the chart, the average investor clearly sells financial assets at an emotional low. Only when markets were making new highs did they find the confidence to buy back in. Aren’t we trying to do the opposite – to buy low and sell high? And why is that common practice only for real estate or consumer products?

Over the long run, the S&P500 (a stock index of the 500 largest companies in the US) has handedly outperformed the average investor, as well as other asset classes. The 5.4% difference between the performance of the S&P500 and the average investor is largely due to market participants trying to time the market rather than simply spending time in the market. Peter Lynch puts the market cycle into perspective:

“In the first stage of an upward market – one that has been down awhile and that nobody expects to rise again – people aren’t talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, ‘I manage an equity mutual fund,’ they nod politely and wander away. If they don’t wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque. When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it’s likely the market is about to turn up.

In stage two, after I’ve confessed what I do for a living, the new acquaintances linger a bit longer – perhaps long enough to tell me how risky the stock market is – before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market is up 15 percent from stage one, but few are paying attention.

In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals take me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they’re all discussing what’s happened.

In stage four, once again they’re crowded around me – but this time it’s to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they’ve all gone up. When the neighbours tell me what to buy, and then I wish I had taken their advice, it’s a sure sign that the market has reached a top and is due for a tumble.”

The next time that markets are on sale, I challenge you to make the rational decision and not allow emotion separate you from your hard-earned money. Moreover, if the meat butcher is giving you investment advice, it’s likely time to call your investment advisor to review your portfolio.