The Single Worst Practice of New Investors

By Markets Fool.com


Avoiding this one practice could make a huge difference in your returns. Source: Flickruser striatic

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The definition of insanity is doing the same thing over and over and expecting different results.-- Variously attributed to Mark Twain, Albert Einstein, Ben Franklin, and author Rita Mae Brown (though it's probably been around longer than all of them).

It's become increasingly clear over the past few decades that the single worst practice of new investors is the same mistake of most seasoned investors: trying to time the market. Data from several long-term studies of both investor behaviors and stock market returns bears this out.

The sad thing about this reality is how pervasive it's been as an investing practice, especially considering just how wealth-destroying it is at the same time. Let's take a closer look at the studies, the implications for investors, and what you can do to avoid the major pitfall that leads investors to buy high, sell low, and leave big money on the table.

Lies, damned lies, and statistics
While numbers can sometimes be manipulated to say what you want them to say, they tell an unusually clear storywhen it comes to investing. Namely,most investors have no idea what the market is doing.

In 2014, theWells Fargo/Gallup Investor and Retirement Optimism Index survey asked investors with at least $10,000 invested in the stock market how the market had performed in 2013 -- one of the best years for stocks in decades:

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^SPXTR data by YCharts

Only 7% of those surveyed believed the market had gone up more than 30%. To put it another way, fully 93% of those surveyed didn't know how how the market did the year before. 9% believed that stocks actuallydeclinedin 2013.

So what?
Okay, fair enough; data like that is only important if there's a meaningful correlation. Consider the study below within the context of poor investor knowledge as measured by the Wells/Gallup survey. This is where ignorance and action combine to produce wealth-destroying results.

Financial services research firm Dalbar's annual Quantitative Analysis of Investor Behavior study for 2014 -- covering investor behavior since 1984 -- shows a significant disparity between the average mutual fund investors' performance, and that of the stock market as measured by theS&P 500. It's not even close.

From 1984-2013, the S&P 500 generated 11.1% in compounded average annual returns. Over that same period, according to the QAIB, the average investormanaged only 3.69% in annualized returns. That's right -- over the past 30 years the average investor into mutual funds has underperformed the market by two-thirds.

Here's how big the impact of this 30-year performance disparity is:

That's life-changing returns left on the table by the average investor.

The table above doesn't include average mutual fund returns for the same period, but before you blame the funds -- especially actively managed funds that charge higher fees -- take a look at another study for context.

According to the S&P Indices SPIVA report -- which measures the performance of actively managed mutual funds against their benchmark indices -- the S&P 500 averaged 7.57% in annualized gains over the past 10 years, while large cap funds averaged 6.81%. The average underperformance of these funds has been relatively close to the amount they charge in fees.

But if we go back to Dalbar'sQAIB, we see that the average mutual fund investor's annualized returns were 5.88% over the prior 10 years, meaning investor actions -- i.e. buying and selling at bad times -- led to the average investor performing measurably worse than the average fund.

An investor simply putting the money in the lowest-cost index fund -- and leaving it alone -- would have achieved the returns closest to the S&P 500. Simply taking no action -- and investing in cheap index funds without managers whose actions don't lead to better returns -- would beat the average.

Find a mirror
In short, it's us. Our actions cost us more than fees and mutual fund underperformance, and keep the average investor from getting anything close to market-beating returns.

The worst part of it is that most investors repeatedly lie to themselves, saying they won't sell out during the next market crash. According to a Wells Fargo/Gallup survey conducted in early February -- again, of investors with $10,000 or more in the market -- 76% said they were either very or somewhat likely to take no action during market volatility. 46% answered that they were either very or somewhat likely to invest more money in a volatile market.

Unfortunately, history tells us that it's just not true. Market volatility -- especially the extreme kinds we see during major economic crises like in 2008 -- is a product of people selling, which leads to even more people doing the same, until eventually the only ones left standing are the few who actually don't sell when the market falls. In other words, you can rest assured that next time you see the market fall or rise by 15% or 20%, it's because a lot of people lied to themselves about what they would do.

Get out of your own way
If you can't outdo the average investor, you'll never beat the market. And the only way you'll be better than average is by learning how you'll respond to adversity when real money is on the line. To start, take steps to understand what you own -- stocks are ownership in companies, after all -- so that you'll be able to tell the difference between a volatile market, and a company that's struggling.

In the meantime, focus on the things youcancontrol today. Ingrain it in your psyche what the data tells us: Short-term thinking and trading -- trying to time the market -- is a wealth-destroying behavior that you have to learn to avoid to be successful. Even if you don't beat the market, you can be above average if you just avoid this one terrible practice.

Over a career of investing, that can be the difference between independence and falling short of your goals.

The article The Single Worst Practice of New Investors originally appeared on Fool.com.

Jason Hall owns shares of Wells Fargo. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Wells Fargo and has the following options: short April 2015 $57 calls on Wells Fargo and short April 2015 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.