It’s no secret that I am all for passive investing. After looking at the data that 80% of active managers fail to beat the market in a given year, you are foolish to pay the higher expenses of actively managed mutual funds. (See my posts about what to look for in mutual funds if you need some guidance.) You are better off buying a lost cost index fund and holding it through the good times and the bad.
I recently came across the below chart and it blew me away. It breaks out the annualized returns of over 20 year specific investment categories. It is interesting to see that after the huge run up in housing prices, the collapse has resulted in the annualized return to be just under 3%, which is roughly the historical average.
But the most interesting part is this: Look at the column for the S&P 500. Over 20 years, it has returned just under 8% per year. That means if you took your money and put it in an S&P 500 index fund and left it alone, your return would be just shy of 8% per year for 20 years.
Now, scroll over to the right and notice the column marked as the average investor. The Average Joe returned a measly 2.8% per year over the past 20 years. How did they come up with this number? The study looked at mutual fund inflows and outflows of money. Another way to say that is the amount of money investors invested in the market and withdrew from the market.
Why such a drastic difference? The answer is because the lack of discipline. When the market drops, investors get scared and take their money out of the market. The market rebounds, but the average investor is still on the sidelines, scared. By the time he or she gets the courage to invest again, the majority of the run-up has occurred. Any gain they get is wiped out as they ride the market back down and sell at the bottom, scared that the market will continue to drop. This cycle repeats itself over and over again.
What does this difference in return look like in dollar terms? Let’s say you invested $10,000. After 20 years, had you invested in the S&P 500 and stayed invested, returning 8% annually, you would have over $46,000. If you bought and sold like the average investor does, you would have $17,000.
How do you avoid being another average investor? Buy and hold. Don’t sell when the market is tanking. It’s not easy. But you have to realize that the market is going to come back. It always does. Look at the drops as buying opportunities. My biggest returns were on investments that I bought after huge market drops.
Tune out the media. They promote fear and exuberance. If the market is dropping, don’t watch the news or read the paper. If you do, laugh when you see the picture of the person on Wall Street with anguish on his face. I swear they have that picture saved for these moments. They always show it.
Lastly, bookmark this post. That way you can easily get to it when you need some support.