What if one decision could make the difference between a return of $1.73 million and $1.1 million? According to John Bogle, the founder of Vanguard, a $3 trillion money manager, the average equity mutual fund investment gained 173% from 1997 to 2011, but the average equity mutual fund investor earned only 110%.
On an investment of $1,000,000, the ‘Do Nothing’ option earned an additional $630,000.
This difference is largely caused by our emotions controlling our investment decisions. In the words of Carl Richards, a personal finance writer, this is our Behavior Gap.
The Behavior Gap is part of a collection of internal biases that cause us, from a rational and logical standpoint, to make sub-optimal decisions. To understand why, look no further than the device that you are reading this on. With the explosion in connectivity has come an explosion in the amount of content we receive, including finance and investment related content. It’s never been easier to check the price of a stock, see predictions on the latest earnings or read someone’s speculation as to where the price will head. This constant stream of information can play on our emotions. When our emotions get involved, we feel the urge to act (trade).
Here’s why you shouldn’t: excessive trading not only costs you brokerage commission and capital gains tax, which grind away at your return, but it can take you out of the market.
According to an Oppenhiemer report, if you missed the 10 best days between 1980 and 2010, your average annual return would have dropped to 5.7% from 8.2%. The more you trade, the higher the likelihood of you missing the big ‘up’ days. An anecdote from fall of 2014 might be the best data against excessive trading: James O’Shaughnessy of O’Shaughnessy Asset Management. a $5.4 billion operation, was on Bloomberg: Masters in Business when the topic of investment performance of the public came up. O’Shaughnessy went on to say Fidelity did a longitudinal study to find out which accounts did best. As it turns out, people who forgot they had an account at Fidelity were the winners by a healthy margin.
That isn’t to suggest that you should buy and forget about what you own. Rather when making the decision to buy, hold or sell a stock, think bigger picture. Will this company be around in 10 years? How has the company been doing recently? Are cash flows growing? Has the company raised the dividend? How much debt is on the balance sheet, and when is it due? Answering fundamental questions about the financial health of the company can give you a better sense of whether it’s the right investment for you.
In addition, when a holding falls in value, try to avoid panicking so you don’t sell blindly. Consider why the price has come off, it’s likely because of two things (1) a macroeconomic event and/or (2) a company specific event. Macroeconomic events affect the whole economy, a financial crisis like in 2007-2008 or the current period of low to negative interest rates are recent examples. These events often influence stock prices ‘across the board’ including the companies that you hold in your portfolio. To date, the global economy has been able to recover from these events and stock prices have rebounded i.e. these declines are temporary. Company specific events are more troublesome. In the extreme cases, executive fraud (e.g. Enron) or the inability to remain competitive (e.g. RIM) can severely affect if not bankrupt companies. These events are much more difficult to rebound from and often have lasting effects. So, if your holdings have come off from their highs, stop and think analytically. Decide whether the decline was caused by macroeconomic events or if its company specific. If it’s company specific and the future prospects look bleak, consider selling, otherwise close your browser and like the top performers at Fidelity, ‘forget about your holdings’ for the rest of the day.