Why Really Smart People Are Still Losing Money

If you want to understand why people are losing money year after year, take a look at the picture above.  It has the key to understanding your problem.  Can you guess what this picture is?

If you guessed “fat snake” you need art lessons more than I do.

Actually, what you see here is a bell curve – or at least my attempt to draw one. If you are an investor, this bell curve is very important because it can help you stop making the costliest mistake ever - trying to predict future returns based on limited past experience.

Before you allow your eyes to gloss over, hold your horses.  This isn’t a statistics lesson. And if you think you’ve never drawn a bell curve, you might want to reconsider.  If you are like most people, you draw these bell curves all the time…at least in your mind…before you invest. You just don’t do it correctly.

Let me show you what I mean.

Let’s say you are considering making an investment.  You look at a hypothetical mutual fund performance. You see that over the last 20 years, the very best years returned a profit of 30% or more.  You also notice that the worst years cost the investors a loss of 30% or more. Most of the returns are bunched up somewhere near the middle…in this case…indicating an average return of zero.  Not too attractive generally.

That being the case, you could draw a bell curve like the one I did above to illustrate what the returns look like.

See that most of the returns fall between +30% and -30%. In our hypothetical example, you could in fact conclude that 95% of the time, your return will fall within those parameters. If you did make such a conclusion, you’d be right.

But if you invest based on that information, you’d be doing so while ignoring the other 5% of the story.

What you’ve done is drawn yourself a defective bell curve subconsciously. You failed to take the tails of the curve into account.  You forgot about the other 5% of the cases, which are the extremes.  This 2 1/2% on either side of the bell is what’s known as the tail. Think “dark side of the moon” or ocean crater.  Nobody knows how deep they are…or when you are going to step into the abyss.

Of course, the 2 1/2% to the right of +30% is wonderful.  It represents those years when the return exceeds 30% and, according to our bell curve, that’s going to happen 2 1/2% of the time.

But 2 1/2% of the time, the performance will be much worse than -30%.  Yikes!  2008 was one of those years.  Need I say more?  The reality is that these “bad surprises” are a possibility and nobody can predict how “bad” they might be or when they might appear.

And people make the mistake of either forgetting about the extremes or thinking that the extremes have become the norm.

Why is this important for you?  Because these tails exist. They occur rarely…but they do occur. Sooner or later, your investment results will fall into the tail.

If you invest while ignoring the tail, you’ll be very…shall we say…disappointed…when your returns fall in the extreme left of the curve.  When that happens, you might make very bad decisions – like cash out your investments and refuse to invest ever again. If you do this, you are in essence saying that the extreme has become the norm.  That the bad times are here to stay.

What I’m saying is that bad things happen to good investors.

That is inevitable and unavoidable. You might do everything right and still fail to achieve your financial goals because you got “the tail.”  This does not mean you should therefore refuse to invest.  You have to compare your alternatives and the risks associated with those alternatives.

So what is an investor to do?

1. Be clear on your financial situation and time horizon.

Create a portfolio allocation based on your real time horizon.  If you are 57 years old and you want your money to last until you reach 85 years of age, what is your time horizon?  It’s 28 years.  Don’t make the mistake of changing your time horizon when things get difficult and uncomfortable.  That usually works out to be a very costly mistake.

2.  Use the right asset allocation to reduce risk.

It’s impossible to be a risk taker when things are good and a risk minimizer when things are bad.  Select a portfolio allocation that will pass the “sleep at night” test in tough situations.  This will allow you to stay invested longer.

3. Understand that things may not work out as you planned.

If you get caught in “the tail” too soon or too long, your plans may not work.  That’s been happening to many people these days. They are coping by reducing their spending and working longer.  If that happens, it doesn’t mean you made a mistake.  You could have made the best decision possible with the information you had available and things still could have turned out poorly.  Have a “Plan B.”

Do you disagree?  Do you think it’s possible to have a fail-proof investment plan?  Are you willing to accept that your plan may not work out?

If you liked this post, read this post explaining the fixed index annuity.