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A Halloween Special: Scary Things Investors Do To Destroy Their Wealth

Welcome to Halloween, the time for all things spooky and scary! In the spirit of this ghoulish occasion, here are some scary things individual investors do to destroy their investing returns.

1. Trading too much

In a land-mark study conducted by professors Brad Barber and Terry Odean titled “Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, it was found that individual investors in the U.S. who traded the most underperformed the market by 6.5% annually.

Closer to home, Barber and Odean had also collaborated with professors Lee Yi-Tsung and Liu Yu-Jane for a similar study of day-traders in Taiwan. Between 1995 and 1999, the day-traders were simply unable to make any profit as a group after transaction costs were accounted for. To add salt to the wound, more than 80% of the day-trading group lost money with only a minority being able to eke out a profit on a sustained basis.

Investor William Smead once said, “As many advisors have told us, your investment portfolio is like a bar of soap. The more you handle it, the smaller it gets.” With studies like the above, Smead is clearly onto something there.

2. Trying to forecast what the markets are doing next

Investors who make forecasts about the direction of shares over the short-term are also known as market timers. And, trying to time the market has been a very expensive mistake individual investors have been making.

Average investor behaviour versus S&P500

Source: John Maxfield,   Fool.com

The chart above shows the annualised returns the average individual investor in the U.S. has made in the 20 years ended 1998, 1999, 2000, and so on. The chart also plots the corresponding annualised returns that the S&P 500 (a broad market index in the U.S.) had achieved for each 20-year block of time. As you can see, the average investor has lagged the market badly.

According to DALBAR, the organisation responsible for the figures above, a big source of the underperformance comes from the individual investor’s inability to successfully time the market.

In case you think it’s only individual investors who can’t forecast what the markets are going to do next, even market gurus have a hard time doing so as well. No wonder investor Nick Murray once remarked that “timing the market is a fool’s game, whereas time in the market is your greatest natural advantage.”

3. Not having a plan

On 10 March 2009, Singapore’s market bellwether, the Straits Times Index (SGX: ^STI), bottomed-out during the Great Financial Crisis. In the vicinity of that date, there were bargains galore. For instance, one of Singapore’s largest banks, DBS Group Holdings Ltd (SGX: D05) was valued at just half its book value back then. For a bank whose earnings and dividends had been remarkably steady throughout the crisis, a price-to-book (PB) ratio of 0.5 was a real steal. Since then, DBS’ shares have grown by 172% in price.

On hindsight, DBS was a great buy during the crisis. But during the event itself, would you really be able to overcome your fears and buy when everyone else was selling? It’s one thing to say you’d be buying during a crisis before it strikes; it’s another to actually buy when one does hit.

We humans have what psychologists call an empathy gap. Simply put, it’s the difference in what we think we will do when we’re in a different mental state as compared to what we actually do. Although we might proclaim ourselves to be bargain hunters before the market starts dropping, when a crisis does emerge, the fearful environment can easily overwhelm and paralyse us, thus preventing us from being able to take advantage of bargain-basement prices. That’s what can happen if we do not have a plan.

To plan out our actions in a crisis beforehand, one good way to do so would be to list down shares we’d like to own but only at lower prices. When there’s a market decline, we can then whip out that list and start buying. In that way, we’d be much better equipped to handle market volatility.

Foolish Bottom Line

These are by no means the only scary things investors are doing to destroy their wealth. But, it’s as good a head-start as any for those wanting to improve their investing returns.

Before I forget, happy Halloween, Fools!

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.