The stock market has raced to record highs this year, but your portfolio may not show it.
Continue Reading Below
In some ways, that's to be expected: A balanced portfolio won't post the same returns as the Dow Jones industrial average or the Standard & Poor's 500, nor should it. You would have to be 100% invested in stocks to mirror the market's performance, and that kind of aggressive allocation may not be appropriate for your risk tolerance or time horizon.
But generally speaking, if the market is having a good year, your portfolio should be, too. If it's not, you may want to point a finger toward yourself.
"The greatest risk is not the volatility of the market but the volatility of your own behavior," says Daniel Crosby, a behavioral finance expert and founder of the investment management firm Nocturne Capital.
Crosby says psychologists have identified behaviors that can hurt the way we invest. Here are three that are most likely to drag down your returns, along with strategies to counteract them.
OVERCONFIDENCE LEADS TO OVERTRADING
The vast majority of long-term investors shouldn't trade frequently; those who do open themselves up not just to more risk but also to increased transaction fees and tax consequences, both of which can drag down returns.
"One of the reasons investors trade more than they should is that they think they know more than they do," says Terrance Odean, a professor of finance at the University of California, Berkeley, who researches investor behavior. "They think they have more ability than they have, they end up trading more than they should, and that hurts their returns."
If you tend to keep an enthusiastic finger on the buy or sell button, stay away from individual stocks and their volatility, which can tempt you to make frequent trades. Instead, invest through index funds, which passively track a segment of the market.
These funds are low-cost and well-diversified , and they frequently edge out even professional investors, like those at the helm of actively managed mutual funds. According to Morningstar's most recent Active/Passive Barometer, which measures the performance of actively managed funds against their passive counterparts, the average dollar in passive funds typically outperforms the average dollar in actively managed funds.
WE AVOID LOSING AT ALL COSTS
"We hate loss more than twice as much as we like comparably sized gains. Win $50 at a casino and it's kind of 'meh' but lose $50 out of your wallet and it ruins your night," Crosby says. Because of that, we may hold on to poor investments longer than we should to put off recognizing a loss, or flee to cash at any sign of a downturn.
When the market is trending down, it's reasonable to expect your portfolio to do the same — and it's wise to stick it out. On the other hand, it's worth regularly evaluating and potentially letting go of market outliers that are suffering sustained losses or investments that no longer fit your long-term plan.
To temper a fear of loss, set a long-term strategy and then try dollar-cost averaging, which involves dribbling a set amount of money into your investments at regular intervals. If you contribute to a 401(k) or make scheduled transfers into an individual retirement account, you already do this.
Because you're always investing the same dollar amount, you're buying more shares when prices are low and fewer when prices are high. The former can take some of the pain out of a falling market, since you're getting what feels like a discount on subsequent purchases.
Investing according to a predetermined plan like this also takes emotion out of the game. "If you're excited, it's a bad idea," Crosby says. "Good investing is painfully boring."
BLINDERS HAMPER OUR DECISION MAKING
If you read only political websites that align with your views or block Facebook friends with opposing politics, you already know what this means: It's the tendency to discount information that discredits your established beliefs.
As investors, we do this in part because we put money — sometimes a lot of money — behind the decision we've made. We don't want to hear it's a bad one.
But that money will benefit from balanced research, both into future investments and the ones you already hold. When you rebalance your portfolio or re-evaluate your strategy, look at each investment as if you're buying it for the first time, and dive into research from varied sources.
And if you can't or don't want to do that? Then you can turn back to an index fund, work with a financial adviser or hold your accounts at an automated financial adviser — often called a robo-adviser — which is an online service that manages investments for you.
NerdWallet: Diversification: An Easy Way to Reduce Your Investing Risk
Morningstar Active/Passive Barometer — Year-End 2016 https://corporate1.morningstar.com/ResearchLibrary/article/796672/the-morningstar-activepassive-barometer---year-end-2016/
This article was provided to The Associated Press by the personal finance website NerdWallet. Email staff writer Arielle O'Shea: firstname.lastname@example.org. Twitter: @arioshea.