How Not to Invest in the Stock Market

In the 10 years from 2014 to 2023, US mutual funds and exchange-traded funds delivered on average around 7.3 percent profit per year. Individual investors, however, received on average less than 6.3 percent from those funds, a difference of around 1.1 percent (2024 Morningstar report). Investors are leaving money on the table.

Why are investors receiving less than the funds they buy? No, this is not due to fees or hidden costs. Those are already (mostly) included in the returns. Investors are missing out on part of the profits, and this has been going on for a long time. For instance, for the 2012-2021 period, funds delivered an average yearly profit of 11 percent, and individual investors buying those funds received an average yearly return of 9.3 percent, a “gap” of 1.7 percent.

The difference might not sound like much, but it compounds over time. If you had invested $10,000 in January 2012 in an average US fund, by December 2021 you would have had almost $28,500. But, if you behaved like the average investor in those funds, you would only have around $24,350. That’s more than $4,000 you would have left on the table.

Why is this happening? The answer lies deep within your brain.

Your Brain on Investments: Buy High, Sell Low.

The human brain learns in many ways, but probably the most important one is reinforcement. If something works, repeat. If something doesn’t, don’t do it again. As we have discussed several times in this blog (for example, here or here), that is all good and well for learning not to put your hand in the fire or which restaurant you like best, but it does not work so well in rapidly changing, complicated environments like the stock market, today’s business world, or your personal relationships.

The main reason that individual investors leave money on the table is poor timing in their buy/sell decisions. According to Morningstar, you would have received a 7.3 percent yearly return, on average, if you had bought a fund in January 2014 and just looked away until December 2023. But that’s not what the average investor did. The typical investor bought and sold the funds at specific times. Many investors buy a fund when it has been performing well for a while, and then sell it when its performance has just been bad.

In other words: buy high, sell low. It’s not a recipe for high performance. But very human! If you have invested in the stock market, you are probably paying attention to financial news. After all, your money is at stake. Your brain will yell at you to get out whenever you see bad news. You are losing money! Sell! And, whenever you see good news, your brain will tell you to jump on the bandwagon. You are missing out on profits! Buy! So you buy high and sell low.

Our intuition is not well-adapted to financial investments. If you listen to your gut, you will always feel bad when investing. If the market goes down, you feel bad because you are losing money, so your decisions were obviously poor. And if the market goes up, you feel bad because you could have invested more, or in better stocks, so you are missing out and your decisions were also poor.

Rules of Thumb for Investment

Unless you are a professional working in the finance industry, you are better off sticking to some simple truths.

1. If you cannot afford the risk, you should not take it. In the short run, the stock market will go up and down, even if historically it tends to go up on average. Market crises will happen again. If you absolutely need the money at a certain point (for retirement, for a big-item purchase, et cetera) and you hit a market crash right before that, it will break you. If you cannot afford that risk, don’t take it. Accept a low return on your savings (buy, say, US treasury bonds) in exchange for security.
2. You might be able to afford the risk financially but not psychologically. If you keep looking at your stocks and find the ups and downs of the market nerve-wracking, you will make poor decisions, and your psychological well-being will suffer. How would you feel if you lost a quarter of your investments? If you find that possibility deeply unsettling, you might be better off staying out of the stock market. There is nothing wrong with accepting low returns in exchange for peace of mind!
3. If you decide to invest, choose boring, simple, diversified funds. Don’t let anybody blind you with reports about the next big thing, or the amazing returns of a product that you do not really understand. If returns could be very high in the future, the risk will also be very high. And if returns have been high in the past, then you are just buying high now. Forget about all that and go for highly diversified funds that follow the overall stock market as much as possible. Independent advice might help with that, or you can just read a sensible book like Tim Hale’s “Smarter Investing.”
4. You should not be impressed with the alleged performance of some fund manager. It has been shown again and again (for example, Clare and colleagues, 2016) that only a tiny minority of fund managers get their market timing right (buy low, sell high), and your chances of picking the few lucky ones are not good. Nobody has a magic ball, and if you chase after those few “star” fund managers, you will just buy high again and inevitably sell low when they fail to perform.
5. Beware of costs and fees! One reason that most active fund managers fail to beat the market is that their funds have high costs. Choose funds that just track a well-known market index and have low costs, for example, exchange-traded funds. Fees compound over the years and eat away at your returns. Always check and reduce all fees. Anything above 1 percent (total) is probably too high.
6. Last, look away after investing (within reason). The market will go up and down. Your brain will keep telling you to sell when it goes down and buy when it goes up. Don’t. Decide on a sensible investment strategy that you are comfortable with, and, as hard as it might sound, do not look at your portfolio too often.