Investing sounds simple: you pick some decent funds, set up a regular payment, wait and riches follow. Unfortunately it’s not that simple, and this is a lesson I’ve had to learn more than once. If you learn it now you can avoid this mistake costing you a fortune, and one that has seriously impacted my own retirement.
After a decade or so of investing, I discovered that my friend (who is an intelligent man, but knows very little about finance) had much better investment returns than me. How could this be? Why am I putting so much effort in to do worse than someone who is putting in hardly any?
The greatest ‘lie’ in investing
If you go online and watch all those wonderful videos about compound investing, they pick a nice figure (usually the long term return from the S&P 500), assume that is the return you will get for your investing life. The immediate issue that should jump out at you is that the odds of any index doing as well as the S&P 500’s history over the next 50 years is optimistic at best, but that’s not even what I’m talking about.
The majority of investors will not get anywhere near that return. So are all those YouTubers lying? No, but they’re missing something that means even if you find the next generation’s S&P 500 (of if the S&P 500 repeats its magic), you probably won’t get anywhere near those returns.
There is a huge gap (which I generally call ‘The Gap’ for simplicity) between what investors expect to get from the funds they invest in, and the amount their . Some is from e.g. poor tax or fee optimisation, but the largest issue by far is our psychology.
Psychology is your largest cost in investing
Oxford Risk research showed that UK investors lose around 3-4% a year from their own behaviour. At £200 a month invested from starting work at 20 to retiring at 70 that’s the difference between a million-pound pot and £275k – £375k (assuming 7% returns). That’s not a small difference, that’s a completely different retirement. Don’t forget £120k is the money you put in, so we’re talking about losing up to 80% of your investment returns!
It is important to say this is an average. Some will lose nothing or even gain money. Many other people will find it sends their returns negative even over a long period of time. In extreme cases it can lose you everything, or if you do something very risky, more than everything.
Oxford Risk refer to this ‘actual’ return compared to what we could be making as anxiety adjusted returns. It points to this being the fear and emotions we have about investing are causing real damage to our investments. It is the real and measurable cost of being humans, rather than just being pure logic machines.
Why do we do it?
It’s important to say this isn’t you being stupid that cause these losses. You can’t go into this thinking ‘well most investors are stupid, I’ll be fine because I’m intelligent’. This is not stupid people making stupid decisions.
Most of these are logical decisions that logical people make, that nevertheless lose you money in the long term. The two main categories are instincts that evolution has taught us will make us survive, and where our ‘great in theory’ plans collide with the messiness that is real life.
Each decision that drives this cost is usually completely sensible in isolation. Given the situation you’re in, it always feels like you’re making the right action. Over a long period of time though, these ‘right actions’ can cost you an absolute fortune.
Where does the cost come from?
So where does that 3-4% actually go? I leaks out of your portfolio through a handful of behaviours we accidentally fall into without noticing. Different people fall into different traps; one may cost you a fortune and do nothing to the next person, and vice versa. Here are some common ones that do a lot of damage:
- Cash: Money saved in cash and cash-like can feel like investments, but are getting nowhere near the returns of other investments, and compared to inflation are usually losing you money. Cautious investors can often have most of their ‘investments’ in cash, costing them a fortune.
- Buy high sell high: When companies are doing well and their shares are soaring, you see the great profits people are making and want some of that too. Unfortunately that is when their share prices are high. When companies go through hard times and all the papers talk of doom and gloom you want to sell to stop all the losses you are making. Unfortunately this is when their share prices are low. We instinctively buy at the top of the market and sell at the bottom, which is the exact opposite of how you make money.
- Fear of the unknown: there’s a known ‘buy what you know’ motto investing, which means you can make good returns investing in areas you know well. The problem is, most investors don’t have detailed knowledge of any part of the industry, which can put them off investing in anything except a very narrow amount of investments. Here in the UK this usually results in most people only knowing about buy-to-let; we understand buying a house and people paying to live in it. The stock market is the big unknown, but avoiding it will cost you the great returns you can make from it.
- FOMO: the boring option may make you more money, but it’s less rewarding mentally to make money with the slow and steady path than get rick quick. Making £5k on an index fund when you read about someone making £100k with the same starting money makes you feel like you’re missing out on £95k. What you don’t see is all of the people who have tried the same thing and lost everything. Unfortunately the ‘boring’ option is much more likely to make you the £100k.
What can you do about it?
How to fight this depends on what your particular issue(s) are. I can see that a fair amount of this site is going to be the different gaps people fall into and how to deal with them. The ‘blanket’ response is usually to make a good, simple plan that can as much as possible run by itself, and then leave your money to grow.
So many of these pitfalls are psychologically based, so the best thing to do is often to remove yourself from the process as much as possible. This isn’t always possible; some investments need more monitoring or reviewing for losses than others, but a lot of fortunes have been made by a simple, maintainable plan put on autopilot.