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Investing: Against The Odds?

Humans are amazing creatures. We've developed complex financial systems and markets that we exploit by buying up parts of companies (buying stocks) or loaning money to companies ( buying bonds) with the intent of making money off of these activities.

It's shameless and unapologetic (as it should be). Like Gordon Gekko (a fictional character from the movie "Wall Street") said: "Greed is good."

But, unlike Gekko, I think the majority of individuals are not investment superstars. They're not corporate raiders. They don't know people on the "inside" that can help them profit on their next investment deal. They don't have the business savvy to invest in 25 different companies every week and turn a profit on every one of them, or even most of them.

In fact, according to an article in psychology today, humans are, generally speaking, really terrible at estimating odds. Of course, the article (titled "10 Ways We Get The Odds Wrong") isn't peer reviewed literature. But, it's still a good read. How does this relate to investing? It's simple, really.

According to the 2010 Quantitative Analysis of Investor Behavior, published by DALBAR Inc., most investors aren't doing so hot. For example, the average equity return over the last 20 years before inflation is a paltry 3.17%. Fixed income investments show a pitiful 1.02% return. Even with what is considered good asset allocation, the returns are only 2.34%. So, it seems that the odds are stacked against investors. But are they really?

My thoughts are that many investors just make dumb decisions. Their poor investment returns can be explained by a few potential issues. First, they're buying and selling at the wrong times, they're making a ridiculous number of mistakes, they don't understand how financial markets and business cycles work, and/or they don't understand what they are investing in. Most of that is completely preventable.

When the S&P500 returned 8.43% with full dividend reinvestment from 1990 to the beginning of 2010 (and you could have made more if you knew enough to get out of the market before the bubble popped), it's a real kick in the pants to realize that you've captured less than half of that in the same time period-especially when buying an index fund is really easy to do (as is buying a collection of stocks that mirror the index). For active investing, you'll need to do more work to beat those returns, but it can be done.

DALBAR's data seems pretty consistent from year to year, which suggests to me that people just aren't learning any lessons here. I think investors need to be more critical in their investment decisions if they ever want to get anywhere near the returns that their investment advisers and mutual fund managers are suggesting.

This entry was posted on July 11th, 2010 by David C Lewis, RFC. Edits may have been made to keep this entry current. · 1 Comment · Investing, Retirement Planning

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