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Here's why you find it hard to invest (plus, what makes the best investors)

By Andrew Hallam - June 13, 2023

“Sir, we’ve cloaked our vessel and we’re in Earth’s orbit.”  

“Well done, Captain. Let’s check their communication devices to see what’s happening.

I’ve studied humans for several hundred years. Would you like to see how they invest their money?” 

“Sir, I saw your latest research. More humans now invest in a diversified portfolio of index funds. Are we studying those who don’t?”  

“No Captain, I want to see how investors in index funds behave." 

“But Sir, don’t they just stick to their target allocation?” 

“Oddly, ancient survival instincts wired into their DNA make that difficult for them, Captain. I’ll tap into some accounts and show you. Here’s one: This human is adding money he has earmarked for retirement into a bank’s fixed deposit account. It’s promising 5 percent per year, not including restrictions that could reduce those earnings. He’s hiding in a cave to protect his food stores. But inflation is higher than 5 percent, so the rising cost of living will act like rats eating his food.” 

“But Sir, even this guy’s bond market index is better than that fixed deposit. Bonds are cheap. When prices rebound, he’ll make interest plus the surge in capital appreciation.”  

“Captain, humans have a tough time perceiving risk. During the year that they call, 2022, stocks and bonds both dropped. This scared many humans, especially those who thought bonds could never fall.” 

“I understand that, Sir. But don’t they know that broad asset classes are safest and likely to be more profitable in the future after they have dropped in value? If this guy adds money to his overall portfolio, he’ll pay lower prices for his stock and bond market indexes. And because that money is diversified, it would be less risky than a fixed deposit at his bank.”  

“That’s true, Captain. But years of evolution is tough to shake.”  

“When will he take that money out of the bank and add it to his diversified portfolio of index funds? 

“Well Captain, based on his primal instincts, he’ll likely do it after bond prices bounce back.”  

“Holy jumping Jupiter, Sir! He’ll forego the cheap prices and miss much higher, future gains.”  

“That’s right, Captain. Here’s another fascinating, behavioural example. Can you see what this woman is doing?” 

“Yes, Sir. She has a diversified portfolio of index funds. But she’s going rogue! She’s placing a large order for an S&P 500 ETF. Why would she skew her allocation and jeopardise her future returns?” 

“Captain, her behaviour is hardwired into her DNA, from generations of chasing Elk on savannahs. She noticed that the S&P 500 went for a recent price run, so she decided to chase it.” 

“But Sir, it’s more expensive now! Yale University’s professor, Robert Shiller, learned that markets with low prices (he calls them CAPE ratios) have better ten-year prospects than markets with higher prices. When people add money to a diversified portfolio of index funds, and maintain a consistent allocation, this ensures they add more money to their underperforming funds. That means they pay lower than average prices.” 

“Captain, even if she saw that research, it might not change what she does. Notice that, over the 15 years ending June 30, 2019, an investment in the S&P 500 averaged 8.62 percent per year. But according to Morningstar, the average investor in that fund, over the same time duration, averaged just 6.34 percent. Sadly, most investors added more money when it was ‘doing well.’ And when it wasn’t ‘doing well,’ they added less. That woman is a case in point.”  

Investors Underperform By Chasing Recent Winners 
(June 30, 2004 - June 30, 2019) 

Fund Fund's average annual performance ending June 30, 2019 Investor's average annual performance ending June 30, 2019 Investor's annual underperformance
Vanguard's S&P 500 8.62% 6.34% -2.28%
Vanguard's International Stock Market Index 5.67% 4.47% -1.20%
Vanguard's European Stock Market Index 5.52% 0.93% -4.49%
Vanguard's Pacific Stock Market Index 5.05% 0.34% -4.47%
Vanguard's Total Bond Market Index 4.12% 3.61% -0.51%

Source: morningstar.com

“Sir, is it true that if I show the average human the 15 year returns of those Morningstar funds in the table above and ask, ‘What would you buy?’ most would pick the fund with the best recent record? In other words, based on the performances posted above, would they avoid the European and Pacific stock indexes because they hadn’t performed as well as the S&P 500?” 

“Yes Captain, that’s what makes them poor investors. Neither they nor anyone will know which will perform best in the future. That’s why smart investors diversify, own them all, and maintain a consistent allocation.” 

“Sir, what other weird things do humans do?” 

“Well Captain, in most cases, their DNA ensures they’re tempted by stories of other people who are supposedly making a lot of money. They love stories about private equity funds and initial public offerings, even though the long-term data suggest both are risky and tend to be poor performers. They also pine for almost anything that has recently become more expensive, whether that’s real estate, gold or crypto. In contrast, they avoid almost everything that’s cheap, like bond indexes right now.” 

“These humans think in such a backward way, Sir.” 

 “Yes, Captain. You’re right. But there’s hope. Those who invest with a diversified portfolio of index funds, who don’t follow investment news, and have no idea (or don’t care) how their individual components ‘are performing’ tend to make the best investors.” 

“Will we see more of them evolve to reach that stage, Sir?” 

 “That’s my hope, Captain. Let’s come back in another 100 years.” 

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Andrew Hallam is the best-selling author of Millionaire Expat (3rd edition), Balance, and Millionaire Teacher.