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The Average Investor Trap

If sports were as predictable as poor investor behavior, you would have stopped watching ESPN long ago out of boredom.

Think the Lakers win all of the time? The reigning champs are working on their third straight NBA title. As impressive as this is, it’s nothing compared to the equity markets when competing against the individual investor.

For the 17th year in a row, last year the S&P 500 beat the average equity mutual fund investor according to Dalbar’s annual report.

Seventeen years in a row? This even dwarfs the dominance of the Yankees in the days of Mantle and Maris. While we may wonder how the market accomplished this feat, perhaps it’s a better question to understand how the Curse of the Bambino has befallen the individual investor.

In 2010, the average equity investor earned 13.6 percent, which wasn’t far off the 15.1 percent increase in the S&P 500. Unfortunately in the sweep of recent history, the average investor fared far worse. They earned 3.8 percent annually over 20 years, versus the S&P 500 at 9.1 percent. Ouch.

To understand the impact of consistent inferiority, consider $100,000 invested from 1991 and held until last year. The average equity investor ended up with $210,837. More than doubling your money sounds pretty good until you look at the S&P 500 investor who finished with $570,815. That’s the difference between a successful retirement and scraping by.

Being average can be devastating to your retirement and higher education plans. The Dalbar report gives some explanations for our “irrationality.” If you can understand the potential sources of financial hara-kiri, you’ll be in better shape to resist selling into the maw of a bear market.

Loss aversion. As a species, we hate to lose much more than we like to win. Psychologist Daniel Kahneman won the Nobel Prize in Economics for establishing that losses have a more profound impact on our emotional state than gains.

This may mean you suffer as much with a 10 percent loss as you benefit from a 20 percent gain. This loss aversion gives you that queasy feeling in the midst of a declining market.

Narrow framing. The long march of positive stock returns is forgotten when we’re embroiled in deep bear markets. Not many investors were able to keep in mind the 7 percent annual real returns of domestic equities over the past two centuries when the market was down more than 50 percent two years ago.

Our memory is short and leads us to uncommon euphoria during rallies and depressions during downturns. The media and its need to fill a 24-hour news cycle can help reinforce these manic tendencies with breathless stories of market breakthroughs and panic-inducing prophecies of impending collapse.

Mental accounting. Whenever an investor attempts to delay some curative transactions using the rationale of not wanting to “lock in the loss,” this is mental accounting.

The fact remains that your investment has already declined in value regardless of whether you’ve sold it or not. Plus the IRS will offer up a salve in the form of capital losses that you can use to reduce your current and future income.

Herding. Humans like company and our investing behavior does not deviate from this maxim. Those who were investing in unprofitable tech stocks in the late ’90s, gold in 1980, and real estate in 2005 were guilty of this mentality.

When combined with narrow framing, herding can lead to doubling down on investments that have already had their day. Is investing in profitless iPhone app companies and gold a good idea right now? The herd will say it is.

Dave Gardner, for the Daily Camera.