Why Average Investors Don’t Beat the Market
Most people invest in order to grow wealth over time. It’s only natural to want the biggest returns possible as part of that process.
But focusing on returns isn’t necessarily a sound investment strategy — and it could be part of what leads average investors to perform so poorly.
In fact, average investors don’t just fail to get big returns and beat the market. They tend to underperform market indices that they invested in, like the S&P 500. In 2015, the S&P 500 index outperformed average investors by 3+% percent and they did the same with the Barclay’s Bond Index!
Theoretically, that shouldn’t happen. An index simply tracks the market. Investors are getting beat up trying to beat the market.
And that’s where they get into trouble.
Why You Shouldn’t Try to Beat the Market
These investors are actively involved in their investments. They constantly watch the market (or the news, or both) and try to predict the best moves to make in order to earn the biggest return.
It’s not just individuals who do this. Some advisors will promise returns, too. If you run into one of these, run the other way. Over time, most active investment managers fail to beat the market just like average investors do.
Again, it’s only natural to want to maximize your ROI. To us as humans, that means we have to work for it and take actions and constantly be striving to earn that return.
But time and time again we see that tinkering with your portfolio — rather than simply sticking to a sound investment strategy that aligns with your goals, risk tolerance, and time horizon — leads to losses, not gains.
What’s going on here? Why can’t smart people use their intelligence to outsmart the market?
There are a few factors at work against you as an individual investor acting alone. Let’s look at 3 of the biggest mistakes you can make that put your portfolio in the most danger.
1. Trying to Time the Market
Average investors get into a world of trouble when they start trying to time the market. Especially when it comes to attempting to sell high.
It’s very simple: no one knows what the market will do tomorrow. We don’t know what it will do next month. We don’t know what it will do next year.
Trying to plan around guesses about what the market may or may not do is setting yourself up for failure. In this case, that means losses.
What we do know is that the market will, at some point, take a nosedive. We don’t know the day. We don’t know where the bottom will be — so it is entirely pointless to try and time it.
Similarly, we know that once the market takes a tumble, it will eventually recover. But again, we don’t know precisely when this will happen. Say it with me: it’s entirely pointless to try and time it.
Investors tend to wait until they feel very confident to buy in after a market crash. Unfortunately, at that point, they’ve missed out on most of the gains and must buy at premiums. The opposite tends to happen during the pullbacks: investors tend to wait for a ‘bounce’ to sell, and by the time they’re convinced they need to sell the market already tumbled. They sell and experience major losses making it even harder to buy on dips!
You nor anyone else has a clue when exactly market peaks or troughs will occur. Don’t try to guess and leave yourself buying high and selling low. Focus on consistency, not beating the market.
2. Giving in to Groupthink
You’ve heard that famous Warren Buffett quote, “be fearful when others are greedy and greedy when others are fearful.” It’s an excellent piece of investing advice that almost no individual investor follows.
Why? We’re biased toward influences from our social circles. FOMO. Fear of Missing Out. You can refer to this as groupthink or herd mentality — either way, we tend to let our desire to belong to a group or community override logical (and even creative) thought. A friend may “beat the market” on a single trade, but a single stroke of luck is not a sufficient strategy for building wealth long term.
Today, of course, our survival wouldn’t be jeopardized if our “herd” kicked us out or if we chose to strike out on our own. But that wasn’t the case thousands of years ago when being accepted or rejected from our groups could mean the difference between life and death.
We go with the herd because we don’t want to get left behind, miss out, or worse, be shunned by the tribe. This happens in all areas of society — including in business and financial markets.
Groupthink can lead us to simply go with the majority opinion while leaving our own critical thought and reasoning processes behind. It’s what drives market bubbles or the desire to buy more and more stocks when everyone else is doing the same.
When others are greedily buying up stocks, and the market is soaring, as Buffett mentioned, there’s reason to be cautious. Similarly, when everyone is panicking and selling shares, it provides the successful investor an opportunity to snap up stocks at bargain prices.
To avoid the mistake of groupthink, turn off the TV. Don’t worry about sensationalized headlines. Ignore your colleague at the water cooler who has the inside scoop on the next hot stock pick.
Stick to your investment strategy, even if it means going against the herd.
3. Not Realizing “No Action” Is a Decision
Sometimes, all the knowledge in the world is not enough to stop investors from doing stupid things in situations where they should know better. It’s not always easy to just sit back and do nothing, especially when you feel emotional.
And investing is a big emotional roller coaster full of very high highs and some terrifying lows. But just like a roller coaster, you need to keep the seatbelt buckled and stay in your seat until you reach the end of the ride instead of attempting to leap off at some point in the middle.
Many of the decisions investors make focus around choosing between one of two (or many) actions. What average investors sometimes miss is the fact that not doing anything is also a decision and a choice you can make.
Avoiding the actions that lead to mistakes is sometimes more powerful than choosing all the right moves to make.
In fact, this is one of the areas where a financial advisor acting as your fiduciary can add the most value: reminding you to stay calm, keep your seatbelt fastened, and ride out whatever has you spooked.