The behavioural mistakes that cost most

Studies comparing fund returns to the returns actually achieved by fund investors consistently find a gap. The explanation is behaviour, and it is more expensive than fees.

The gap

Investors as a group tend to buy after periods of good performance and sell after periods of poor performance.

Because money flows in near peaks and out near troughs, the dollar-weighted return investors achieve is generally lower than the time-weighted return the fund reports.

Estimates of the size of this gap vary by methodology and period, and the direction is consistent across studies.

The practical implication is that the largest determinant of an individual's investment outcome is frequently not what they own but what they do with it during difficult periods.

Selling during declines

The single most damaging behaviour.

Market declines feel like the beginning of something worse, because that is what the coverage during them suggests.

Selling converts a temporary decline into a permanent loss, and it creates a second problem: deciding when to return.

People who sell during declines generally do not reinvest at the bottom. They wait for confidence, which returns after prices have already recovered substantially.

The result is participating in the decline and missing part of the recovery, which is the worst available combination.

The specific biases at work

Loss aversion. Losses are experienced more intensely than equivalent gains, which makes declines feel more significant than they are.

Recency. Recent experience dominates judgement, which is why people are most cautious after declines and most confident after gains.

Action bias. Doing something feels better than doing nothing, particularly under stress, and in investing doing nothing is frequently correct.

Overconfidence. The belief that you can identify when to exit and re-enter, which is a skill that professionals have not reliably demonstrated.

Narrative. Compelling explanations for why this time is different are always available and are always available.

What actually protects against it

A written investment policy. A short document stating the target allocation, the rebalancing rule, and the circumstances under which anything would change.

Written when calm, consulted when not.

Automation. Automatic contributions, automatic rebalancing where available. Decisions not made cannot be made badly.

Looking less often. There is research suggesting that more frequent evaluation of a portfolio leads to more conservative choices and worse long-term outcomes, because more frequent observation means seeing more losses.

Quarterly is ample for most people.

An allocation you can actually hold. The best portfolio is not the one with the highest expected return but the one you will not abandon.

Someone who would sell an eighty per cent equity portfolio during a decline is better off with sixty per cent held throughout.

Cash reserves. Knowing that near-term spending is covered makes it considerably easier to leave the rest alone.

Another person. An adviser, a spouse, or anyone who has agreed to be consulted before any significant change.

Much of the value advisers provide is documented as behavioural rather than analytical, and this is the mechanism.

The retirement-specific version

Two errors particular to this stage.

Becoming too conservative. A portfolio that eliminates volatility also eliminates the growth needed to outlast inflation over thirty years.

This feels prudent and is a different risk rather than less risk.

Underspending. The mirror image of the fear of running out.

Research consistently finds retirees spending less than their assets would support, and dying with substantial unspent balances.

That is a failure too, and it is far more common than the outcome people fear.

The honest summary

Selecting investments well is worth something. Keeping costs low is worth more. Not doing anything stupid during a decline is worth the most.

The third item is the hardest, and it is the only one that requires no expertise.

The advice-seeking trap

One more pattern worth naming.

People tend to seek new advice after poor performance, which means changes of strategy cluster at market lows.

Switching adviser, switching approach or switching allocation after a decline generally locks in the loss and starts a new strategy at the point the old one was about to recover.

The reasonable time to evaluate an approach is against its own stated expectations, not against the most recent quarter.

A strategy that behaved exactly as described during a decline has not failed — it has done what it said it would do.

General information only, not financial advice. Past performance does not predict future results — consult a qualified adviser about your own situation.