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Why investors are their own worst enemy

(MoneyWatch) History shows that mutual fund investors generally increase inflows after observing periods of strong performance. They buy at high prices when future expected returns are lower, and they sell after observing periods of poor performance when future expected returns are now higher.

This results in what author Carl Richards called the "behavior gap," in which investor returns are well below the returns of the funds in which they invest. Perhaps with this observation in mind, Warren Buffett once said, "The most important quality for an investor is temperament, not intellect."

Market research firm Dalbar estimates that for the period from 1991 through 2010, while the S&P 500 Index returned 9.1 percent the average mutual fund investor earned just 3.8 percent. For the same period, bond investors earned just 1 percent, compared with the Barclays Aggregate Bond Index return of 6.9 percent.

Dalbar's 2012 report, "Quantitative Analysis of Investor Behavior," showed similar results, with the average stock fund investor underperforming the S&P 500 by 7.9 percent in 2011. "The poor performance shows that psychological factors continue to harm the average investor and the remedies for these behaviors remain a work in progress," the report states.

In his wonderful book "The Behavior Gap," Richards recommends asking three questions before you make investment decisions based on your own or someone else's forecast:

  • If I make this change and I am right, what impact will it have on my life?
  • What impact will it have if I am wrong?
  • Have I been wrong before?

Asking and honestly answering those questions should have you acting more like Buffett (who recommends against trying to time the market, but tells those who do it to buy when others are panicked sellers) and less like the majority of investors who are engaging in behavior destructive to their portfolios.

Here are some other questions you should ask yourself if you believe that you're best served by being your own advisor.

  • Do I have the temperament and the emotional discipline needed to adhere to a plan in the face of the many crises I will almost certainly face?
  • Am I confident that I have the fortitude to withstand a severe drop in the value of my portfolio without panicking?
  • Will I be able to re-balance back to my target allocations (keeping my head while most others are losing theirs), buying more stocks when the light at the end of the tunnel seems to be a truck coming the other way?

As you consider these questions, think back to how you felt and acted after the events of Sept. 11, 2001, and during the financial crisis that began in 2007. Experience demonstrates that fear often leads to paralysis, or even worse, panicked selling and the abandonment of well-developed plans. When subjected to the pain of a bear market, even knowledgeable investors fail to do the right thing because they allow emotions to take over, overriding the brain.

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