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The High Cost of Bad Investment Decisions

THE HIGH COST OF BAD BUY/SELL DECISIONS Ask 10 people what investing means, and chances are they'll all say "growing your money." Yet despite popular Hollywood portrayals of how investing works, research shows that most of us still try to time the market, typically resulting in buying high and selling low. Today, we examine why many of our buy/sell decisions are wrong, the damage it does to our portfolios, and a better way to invest for maximum returns over the long run. The Costs: How Poor Decisions Devastate Your Portfolio Investors are clearly harmed by their delusions of stock market expertise-but can we dollarize the exact financial impact? Return of Average Investor vs Retum of S&P 500 FIRST, SOME CONTEXT: 11.9% 8.4% By simply investing and keeping their money in the According to Dalbar, the average stock fund investor (due to poor buy and sell decisions) averaged just a 1.9% annual return over 20 years ending in 2008. S&P 500, investors could have earned 8.4% over the same period. (If they invested in diversified portfolios they would have done even better!) If we run these numbers over a simulated example, that means. SOMEONE WHO TRIED TO TIME THE MARKET: SOMEONE WHO INVESTED IN THE S&P 500 INDEX: INVESTMENT TIME FRAME: 20 YEARS INVESTMENT TIME FRAME: 20 YEARS RATE OF RETURN: ·1.9% RATE OF RETURN: 8.4% INITIAL INVESTMENT: $1,000 INITIAL INVESTMENT: $1,000 ANNUAL INVESTMENTS: $6,000 ($500/MO) ANNUAL INVESTMENTS: $6,000 ($500/MO) INFLATION: 3.1% INFLATION: 3.1% TAX RATE: 15% TAX RATE: 15% INVESTMENT RETURN: $22,968 INVESTMENT RETURN: $150,572 TOTAL INVESTED CAPITAL: $121,000 TOTAL INVESTED CAPITAL: $121,000 TOTAL VALUE AFTER 20 YEARS: $143,968 TOTAL VALUE AFTER 20 YEARS: $271,572 In this simulation, poor buy/sell decisions cost the market timing investor $127,604 in squandered returns, just in comparison to the S&P 500 Index! The Problem: The Overwhelming Majority of Buy/Sell Decisions Are Wrong You might think that you make smarter decisions than the masses, but research says you are wrong. Instead of staying the course, emotional biases drive investors to respond to the market's ups and downs in a way that harms their financial well-being. 85% Recently, Barrons revealed that 85% of all sell or exchange decislons are Incorrect. Emotional Biases That Lead to Poor Investing Decisions People typically sell stocks when they hit rock bottom, and put their money in conservative assets like bonds when they are at the top. The dot-com bust was a classic example. In 1999, when the dot-com bubble swelled, the NASDAQ was up over 85% for the year. 50% Did investors proceed with caution? No, they just kept on buying. Yet on the way down, with the S&P 500 down over 50% from its highs, investors couldn't sell fast enough. What kinds of biases explain such blatantly irrational behavior? In. LOSS AVERSION MENTAL ACCOUNTING OVERCONFIDENCE ANCHORING SUNK COST FALLACY Irrational preference Putting funglble assets Into arbitrary mental categories, such as "money I need" vs. Having higher confidence Heavilly emphasizing Allowing past expenditures for avolding a loss rather than see ing a galn. "I'd rather avoid a $5 fee than get a $5 discount." than you should, such as thinking you time the market correctly 90% of the one or two attributes to influence future decisions. while ignoring all others. "This company's P/E ratio is solid, and that's all that matters." "But I've poured so much money Into this stock, I can't dump It now!" "money I can afford to lose." time, when you are actually wrong 50% of the time. These biases lead us to make decisions (like buying high and selling low) that are clearly illogical, but feel right. The Solution: Stick to a Long-Term Investment Plan That Overcomes Your Emotional Biases With a long-term plan, you don't have to time the market or get caught up in short-term decisions: Achieve diversification across Establish a strategic asset allocation allgned with your long-term goals. Rebalance perlodically to ensure your asset allocation stays on track. several asset classes. Had you invested in a reasonably diversified porffolio (whether it was conservative, moderate, or aggressive) from 2000-2011, it would have dramatically outperformed the S&P 500: Benefits of a Diversified Portfolio (Portfolio Value) $200,000 S188 253 $186 264 $179,916 Š171,687 - CONSERVATIVE $186,803 $185.826 MODERATE AGGRESSIVE S&P 500 INDEX $150,000 S148,005 S132,523 S120,473 SI12.109 S113,175 S103,602 $100,000 ST1277 $62,287 $50,000 $0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 (End of Year) www.JEMSTEP.COM By the end of 2010, $100,000 invested in any of the portfolios would have been valued at over $180,000 versus less than $104,000 for the S&P 500. That's outperformance of 80% with less risk! 90% Roughly 90% of your portfolio's volatility cormes from your asset allocation, not day-to-day micro decisions about when to buy or sell. By maintaining a balanced portfolio, you can actually outperform average investors and, for that matter, the S&P 500. Sources: •14 Years of Darts on Wall Street Lead Malkeil to Reassert jemstep Stock Theory by Daily Princetonian •Investment Returns Calculator by AARP •Www.DALBAR.COM •www.JEMSTEP.COM/BLOG

The High Cost of Bad Investment Decisions

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