Why Most Investors Don’t Make Money In The Stock Market

So you want to make money in the stock market? The best way to start out is to educate yourself about investing, and the most favorable way to do this is to partake of free investment and trading resources from the best online brokers around. I wholeheartedly believe that knowledge is power.

However, here’s a reality that many people don’t realize — that the average investor may not be doing too well with their stock investments. There could be a variety of reasons for this — here are some of the thought patterns that people have about investing:

Personal beliefs: The stock market is for gamblers!

The stock market is for gamblers! Complicated behaviors: I’m having too much fun trading my bucks away. Buy high, sell low.

I’m having too much fun trading my bucks away. Buy high, sell low. Lack of experience and information: Why bother learning? There are pros for this sort of thing!

Why bother learning? There are pros for this sort of thing! Interest: The stock market is for geeks. Too boring for me.

So given all these tendencies, what kind of results does the average investor yield?

The Average Investor’s Scorecard

#1 Investor Performance

The sobering fact is that the typical equity mutual fund investor’s portfolio has lagged inflation from 1984 to 2003, while barely beating inflation over the last couple of decades, according to a study done by Dalbar, a Boston investment research company. Numbers tracked from 1986 through 2005 show:

The average investor earned 3.9% a year, before taxes!

Inflation grew 3.0% a year.

The S&P 500 ($INX) earned 11.9% a year.

The average equity mutual fund returned 9.3% a year.

These points are representative of the information provided by The Skilled Investor, who wrote about a formal study made from 1991 through 1997 that showed that most individual investors handled their investments poorly. Interestingly, these seem to mirror the casual, empirical data I’ve previously gathered.

On average, the portfolios of investors in this study held four stocks in 1991 and seven in 1997. About 25% of accounts held only one stock, and about half held one or two stocks. On a risk-adjusted basis, this lack of diversification was quite costly to these investors. When compared to the broad market portfolio, 80% to 90% of these investors’ portfolios underperformed the market over the period of the study.

#2 Investor Knowledge

What else do we know about the average investor? Now the National Association of Securities Dealers (NASD) also conducted a survey that tested the knowledge of 1,086 investors who’ve made at least one investment in the past and whose portfolios ranged from $10,000 to $500,000. Not bad numbers! Still, the results were very surprising. The survey covered some basic investing and financial questions and here were some unexpected findings:

Assumptions: Over two-thirds of the survey respondents (69%) admitted to being at least “somewhat knowledgeable” about investing with only 12% believing they were “not at all knowledgeable.” 60% owned stocks and 60% claimed they owned mutual funds.

Almost half of the respondents believed that stocks are insured against losses.

70% of the survey respondents did not understand that when one buys stock on “margin,” he or she can lose ALL of the investment, even if the value of the shares does not go to zero.

80% did not know the definition of a “no load” mutual fund. The survey also suggested that many investors do not know the difference between loads (sales charges) and normal operating expenses of mutual funds.

60% did not understand that if interest rates rise, most bonds lose money.

Almost 70% of the survey respondents did not understand why municipal bonds offer lower pre-tax yields.

21% replied that they expected annual returns of 15%-25% from a broadly diversified U.S. stock mutual fund over the long run.

49% of respondents did not know that stocks produced higher average returns than most other investments over the long term.

28% did not understand the link between investment performance and risk.

Most interesting of all were the overall takeaways from the study:

Only 35% of respondents scored a passing grade on the NASD survey. 97% admitted they needed to be better educated about investing. The NASD did provide a breakdown on which groups fared best in its survey. The notable findings are: older respondents (50+) did better than younger (21-29) respondents

men did better than women

higher income ($100,000 and greater) did better than lower income (less than $50,000)

primary decision-makers did better than shared decision-makers

What’s quite telling here is how the average investor actually underperforms the average mutual fund, most likely because of the investor’s common behavior of switching from one fund to another, chasing returns while buying high and selling low. If instead we stay put with a given investment, we’d be tracking that investment’s performance and perhaps have a better chance of matching benchmark returns.

Given the kind of showing we’ve seen in the knowledge test, I suppose it’s easy to understand why the average investor holds a portfolio that has returned 3.9% over the last 20 years or so.

Explaining Poor Market Performance

So why are most people unable to make money in the markets? I’ll boil it down to a few reasons: lack of information, inexperience and arrogance. The stock market can eat you alive when you haven’t studied it enough and you decide to jump in without much understanding. The stock market may also humble you if you think you’re way too smart for it and decide to embark on the quest to beat it year after year.

I’ve decided I’d like to make money in the markets with the least amount of work possible, and a diversified portfolio of index funds should do the trick. No rocket science here, but unfortunately, too many of my buddies just don’t buy it.

Additional Reading:

2001 Dalbar Study: Quantitative Analysis of Investor Behavior Report

2003 Dalbar Study: Market Chasing Mutual Fund Investors Earn Less than Inflation

2004 Dalbar Study: DALBAR Study Shows Market Timers Lose Their Money

2007 Dalbar Study – Quantitative Analysis of Investor Behavior Report

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