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The Powerful Psychology Undermining Your Returns

A woman scratching her head looks at an electronic board showing the graph of the recent fluctuations of Japan's Nikkei average outside a brokerage in Tokyo June 19, 2014. REUTERS/Yuya Shino/Files

There can be little dispute over the sad state of returns for many investors. My colleague at the BAM Alliance, Carl Richards, used Morningstar data to note this disturbing fact: The average U.S. stock mutual fund had a 10-year average return of 8.18 percent at the end of 2013. The average investor only earned 6.52 percent on his or her investments.

Although it's sad the average investor can't achieve returns equal to the returns of the average mutual fund, the reality can be much worse. Many investors hold only individual stocks. There is evidence that their returns from these holdings would be significantly higher if they simply bought and held them, rather than trading in and out, according to a 2004 University of Michigan paper, "What are stock investors' actual historical returns?" by Ilia D. Dischev.

There are many causes of bad investor behavior. See if you recognize yourself in any of these scenarios:

You try to predict the future. If the CEO of a major corporation justified a course of action to the board of directors by saying it was "based on a vision," the loss of confidence in that person would be immediate and the ramifications would be profound. Yet, I have heard many intelligent people tell me they base investing decisions on little more than predictions about random events. Here are some of the justifications I have heard:

-- "I have a software system that signals when to buy and when to sell."

-- "Emerging markets are primed for continued outperformance."

-- "It's obvious we are headed for a market correction. I am going to sit on the sidelines until things settle down."

Data gathered by CXO Advisory Group, LLC, from 2005 to 2012 looking at 6,582 forecasts, indicates that predictions by stock "gurus" are no more accurate than you would expect from random chance, yet many investors continue to rely on such forecasts, often to their determent.

You let emotions drive your decisions. If the same CEO mentioned above attempted to justify a decision by arguing that it "just feels right," the board would react in the same way. Yet, many investors base critical decisions solely on their emotions. Here are some examples:

-- "This bull market has legs. I am buying more stocks."

-- "I have no confidence in the Fed. I am getting out."

-- "I can't sell this stock now. My loss is too big."

Investing based on emotions can be very dangerous. A Vanguard white paper, "Principle 4: Maintain perspective and long-term discipline," makes a compelling case for a disciplined approach to investing that minimizes the role of emotions. The paper concludes that trying to outguess the market and changing your risk profile based on those guesses can be risky and costly.

You are influenced by the media. Every day, the financial media disseminates a massive amount of information. It's only natural that many investors believe it's necessary to consume and analyze as much of the data as they can about the stock market, the economy and individual stocks and bonds. Here are some typical CNBC headlines for these articles:

-- "Jim Cramer's Two Oil Stocks to Own Now"

-- "16 Wild Stocks Paying Off for Investors"

-- "A Look at Five Hedge Fund Stars of the Future"

As I've noted in previous blog posts, the glib experts dispensing this financial "advice" are really emperors with no clothes. I can't find any evidence that their views are any more reliable than what you would expect from random chance. In fact, their odds may be even worse.

If you are investing based on their musings, you are gambling with your financial future.

The rationale for irrational behavior. You may find it helpful to understand why you are addicted to the investing mistakes that prevent you from achieving market-based returns. The answer may lie in a psychological principle called "the rule of consistency." This rule is extensively discussed by Robert Cialdini in his book, "Influence: Science and Practice."

In brief, the rule of consistency describes a powerful force that compels us to act in a way that is consistent with our past behavior. Once we form an opinion (about investing, politics, social issues, etc.) it's very difficult for us to change our minds.

Examples are plentiful. We stay loyal to certain brands without considering the merit of new ones. We hold on to beliefs about political candidates even when there is new evidence that should compel us to reexamine those suppositions. We use an iPhone and refuse to be educated about new Android devices. If we invest by relying on the factors I have described, we are loathe to change the way we approach this complex subject.

Psychologists have a fancy name to describe why we adhere so strongly to our beliefs. They refer to a "decision heuristic," which explains the need to adopt easy shortcuts in making complex decisions. It is far easier to stick to what you are doing rather than spend the time, effort and expense to learn about a different way to invest.

There's no reason why you should continue to be a victim of bad investment decision-making. Perhaps the recognition that these decision shortcuts prevent you from earning higher returns is sufficient motivation to change the way you invest.

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth advisor with Buckingham. He is a New York Times best-selling author of the Smartest series of books. His latest book is "The Smartest Sales Book You'll Ever Read."

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