People put themselves in a risky position when they decide to do their own financial planning
and manage their own investments. Think of the largest and smartest pots of money in the
world: Bill Gates’ fortune, IBM’s pension plan, Harvard’s endowment. Does Bill Gates “wing it”
and write up his own estate planning documents? Does a staffer in IBM’s accounting
department gamble the firm’s pension on the latest hot stock tips? No. The smartest and
richest people and institutions in the world hire the best money managers they can.
Why does this matter? Because amateur investors hurt themselves and their returns. Dalbar’s annual study (1) shows that over the 20 years through 2006, the S&P 500 index returned 11.8%
a year. The average mutual fund returned a few percent below this due to costs, however, the average mutual fund investor only earned 4.3% a year. How is this possible? The average
mutual fund investor hurt their own returns by buying high and selling low, in other words, investing like an amateur. This article details the difference between amateur and professional investing and how individuals can better reach their goals by working with a professional investment advisor.
The Difference Between Amateur and Professional Investing:
Amateurs Professionals
Haphazard Approach Driven by a Plan
Emotions – Fear and Greed Rebalancing to Plan
“Beat the Market” Mentality Risk / Reward Analysis
Worry about what they Focus on what they
CAN’T control CAN control
Haphazard Approach versus Driven by a Plan
Individuals have a haphazard approach to investing. This results from not having a financial plan. Without a plan, you don’t know how much to save, how much to spend, or what to invest in. You are guessing. Professional investors and institutions have a plan called an Investment Policy Statement which describes the institution’s goals, risk tolerance and investment guidelines.
Emotions – Fear and Greed versus Rebalancing to Plan
Amateurs invest according to their emotions and their emotions are driven by fear and greed.
The Dalbar study shows that individual’s behavior has a negative contribution of several percent
a year in their performance. Individuals buy high and sell low. Professionals invest according to their plan, not according to their emotions. That plan forces professionals to rebalance their portfolios. As an example, let’s assume a pension plan had 50% of its money in stocks and 50% of its money in bonds. Let’s also assume it was a bad year for the stock market, so stocks went down, while bonds went up, causing the portfolio to shift to 60% bonds and 40% stocks. The pension plan would rebalance by selling some of the bonds and putting that money into stocks
to get back to a 50/50 weighting. This forces the plan to buy low (it bought stocks after they went down) and sell high (it sold bonds after they went up). Rebalancing also forces the portfolio to return to a risk level consistent with the plan’s objectives.
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