When it comes to doing well in the stock market, there’s one distinction that you really need to know about: the difference between investment returns and investor returns. Confused? Read on.
Mind the gap
The ‘behaviour gap‘ was coined by financial planner and author Carl Richards as a way of explaining why the amount of money made by investors is often a lot less compared to the sorts of returns you see advertised in the financial press.
Investment returns refer to the historical performance of stocks, funds or, more generally, indexes like the FTSE 100. The closest we can get to achieving the latter (remembering the need to take into account commission fees, stamp duty and tracking error) would be to buy a fund that mimics the market’s top tier and do nothing else.
Contrast this with investor returns — the performance achieved by active investors. This tends to be a lot less than investment returns due to the average market participant’s tendency to make emotion-laden decisions.
First, we’re more likely to purchase a stock that’s rising than falling. In other words, we buy what’s popular and avoid (or sell) what’s not. What’s more, we’re likely to feel rather confident about our own investing prowess after doing so.
This is understandable but illogical behaviour. As Warren Buffett remarked, if stocks were hamburgers, we’d be thrilled if they fell in price (assuming we love hamburgers). The fact that we feel awful when stocks fall exposes our frequently topsy-turvy approach to investing.
Second, as humans, we have trouble sitting still. With 24/7 news coverage, that’s perhaps understandable. When commentators are predicting the likely impact of a trade war or worsening relations with Russia, it’s easy to see why some investors overreact, especially if they’re nearing retirement. The bias towards taking action protected us thousands of years ago but it can be a burden as far as investing goes.
So, knowing that our returns have the potential to be far less than what they otherwise could be, what can we do to reduce this gap?
Perhaps inevitably, the best way of improving your performance is learning to act as little as possible. Recognise that you can safely ignore 99% of what’s happening today if you plan to stay invested for decades.
To be clear, the more often you interfere with your portfolio, the greater the likelihood that you are reducing your potential returns. Beyond the occasional profit-taking or re-balancing of assets, there’s really no reason to get involved if your financial goals haven’t changed and your investing endgame is still many years away. If you want to make sure that your returns match those of the market, simply buy an index tracker or exchange-traded fund and be done with it.
If you still have trouble trusting yourself not to lose your head when the next bear market arrives, consider seeking help from a financial adviser. Their fees will eat into your returns but perhaps less so than if you were in charge of monitoring your own fear and greed.
Bottom line? Success in the stock market doesn’t necessarily require picking the best-performing stocks. It’s about knowing yourself and learning to control your own behaviour. If you can do this then you stand a great chance of outperforming the vast majority that can’t.
It's easy to make a million by using a simple strategy such as tracking the FTSE 100 and letting your money work for you. Unfortunately, most investors 'over-trade' and, as a result, their returns suffer significantly...
To help you avoid this key mistake, the Motley Fool has put together this free report entitled "The Worst Mistakes Investors Make". These mistakes can cost you thousands over your investing career but the best part is, this report is free to download.
Click here to get your copy today.
Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.