Why Really Smart People Lose Money

by Neal Frankle, CFP ®

ben-bell-5

Please look carefully at the picture of the bell curve above. It is  the key to understanding why most people lose money investing.   The good news is that once you understand this picture it can help you avoid making catastrophic investment mistakes.

Don’t worry. This isn’t a statistics lesson. But even if it were, you know a lot more about statistics than you think.  In fact you draw these bell curves all the time…at least in your mind. But you may not be doing it correctly.

Let me show you what I mean.

Let’s say you are considering making an investment in a mutual fund. You look at  the fund performance over many years and there is plenty to like.  You find that over the last 20 years, it had a number of great years.  And you perk up even more when you see that it returned a profit of 30% or more several times. At the same time you notice some bad news.  During the worst years investors lost  30% or more.  That also happened a number of times.

That being the case, you could draw a bell curve like the one I created above. If you did draw that bell curve it would accurately describe the past performance of this hypothetical fund.  Most of the returns fall between +30% and -30%.   And if you were a statistics freakazoid, you could conclude that if you buy this fund, your returns will fall between  +30% and =30%  95% of the time. If you did come to such a conclusion, you’d be right.

The Problem

The problem is that you’ve failed to address the other 5% chance of an outlying event occurring otherwise known as “the tail”.  Sure you acknowledge that there is a 2 1/2% chance of something really great or really awful happening intellectually.  But in your heart, you dismiss it.  “It won’t happen to me” is what you tell yourself.

Of course, the 2 1/2% to the right of +30% is wonderful. It represents those years when the return exceeds 30%.  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 occur.

The Big Problem

Some people make the mistake of forgetting about the extremes as I mentioned above. Others think that once the extremes happen, those extreme returns are the new norm. Both of these conclusions are flawed, dangerous and expensive.

If the market tanks and you decide to never invest again, you’ll be selling low and forgoing any potential for future growth.  You also potentially jeopardize your financial future and retirement.  Ouch.

When your investment returns fall into the right tail, it’s equally as dangerous to expect those sky-high returns to repeat themselves year after year.  You might chase return without considering risk.  Some day that chicken will come home to roost and you’ll be the one who gets cooked.

So what is an investor to do?

Do you want some help making better investment decisions?  Do you have investment questions?  Why not considering connect with me.?

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

Create a portfolio allocation based on your real time horizon. Say 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. Even if you get clobbered with a terrible market, it may not mean that much in your overall plan.  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.  Acknowledge worst-case scenarios and be willing to accept them or use an investment strategy with less risk.

2. Use the right asset allocation to reduce risk.

It’s very dangerous to take on more risk when things are good and suddenly become very conservative 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.  The chances of this happening are low – but they are there.  If you build your whole investment strategy as if the worst will happen, you’ll be ignoring the other 97 1/2%  chance that things will be much better.  That’s like staying inside all day because of the slight chance you might get hit by a bus.  Is it possible?  Yes.  Is it likely?  No.

And if you do get hit by a “financial  but”, you  still have options.  You can reduce spending and/or work 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.”

Don’t get me wrong.  I believe that you can and should use an investment strategy that recognizes risk and adjusts your portfolio accordingly.  But no matter what you do, there is no guarantee that it will work.

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?

 

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{ 2 comments… read them below or add one }

Neal June 10, 2009 at 5:14 AM

Thanks Ken. I have found that it’s very east to focus on the long term – when the market is going up.

True Wealth Pilgrims need to keep this idea in mind when the going gets tough. Thanks for a great reminder.

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Ken June 9, 2009 at 3:57 PM

Great post Neal..there is always risk involved in investing…we always need to understand it’s a long term mindset. I did pull some of my investments back in08 but only about 15%. I need to re allocate like yesterday.

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