Investors flee the market, miss big gains

Mutual funds experienced their sixth straight months of withdrawals in October, meaning many investors missed October's rally.
Courtesy of Flickr user cowlet

We've already seen investors miss the greatest bull market of the past 70 years due to panic selling from the 2008 bear market. Now, it looks like the same panicked selling caused investors to miss out on big gains once again.

Investors withdrew almost $18 billion from the market in October, marking the sixth straight month of withdrawals seemingly in response to the market dip we experienced from May through September. It was bad timing, as the S&P 500 Index returned almost 11 percent in October, more than the annualized return the market has provided over the long term.

Study after study shows that the returns investors earn are well below the return of the very funds in which they invest. Advisor, columnist and author Carl Richards coined the phrase the "behavioral gap" to label the difference between investor returns and investment returns.

The gap is created because investors persistently follow a pattern of buying high after a period of strong performance (as greed and envy take over) and selling low after a period of poor performance (as fear and panic take over). They sell when things go bad, when valuations are low and expected returns are high. Then they buy when the coast appears to be clear, when valuations are high and expected returns are low.

Surely investors can't believe that buying when expected returns are low and selling when they're high is a good strategy. Yet, they persistently repeat this behavior.

If you find yourself reacting to the noise of the markets, allowing your emotions to take over and following this cycle, it's time to break the pattern of destructive behavior. Admitting you have a problem of addictive behavior is the first and necessary step on the road to recovery. However, it's not a sufficient one.

The second step is to write and sign and investment policy statement, one that defines your goals and makes sure your asset allocation doesn't cause you to take more risk than you have the ability, willingness or need to take. My book, The Only Guide You'll Ever Need for the Right Financial Plan, provides you with the knowledge you need to build that plan.

The third step is actually the hardest, having the discipline to adhere to the plan. Helping investors do that is perhaps the most important role a financial advisor plays.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.