This Investing Mistake Cuts Returns in Half

Katie: Welcome back to The Money with Katie Show, Rich Girls and Boys, where the rules are made up and the points don't matter. At least, that's how things feel right now in hashtag #thiseconomy, where the stock market seems utterly unperturbed by the absolute shitstorm that is raging around it. We narrowly avoided a looming debt crisis. We have rising rates, we have record high unaffordability of everything from blueberries to homes, and yet, it's hard to believe, but as of the time of this recording—we are recording on June 21st—the S&P 500 is up 14% year to date, 14.5% to be precise, which defies all expectations and frankly all common sense about what the stock market should be doing in 2023, given, well, I am wildly gesticulating to everything around us right now, and I think therein lies the lesson. 

When you ignore the advice to buy and hold, you are doing so at your own peril. Those who jumped ship in 2022, they looked at the world around them and they figured, you know what, I'm gonna wait out the bleeding and then I'll hop back in. They're now looking at prices that are 14% higher than when they dipped out. Unless you think that these folks don't exist or that only those who have not been inoculated by the sound of my droning voice every week would make such a silly mistake, consider this: While the stock market returns about 10% per year on average before adjusting for inflation, the average investor will only get about half that. Let me say that again. The average investor’s returns will be roughly half of what the S&P 500 returns over the long term. So let that sink in while we take a quick break.

So I've written in the past about how it's possible that the average 10% per year estimate might not happen in the future, partially because assets are still relatively overpriced right now. But I ended up settling recently on a far less sinister explanation for why the average investor should not bank on 10% average returns, and that's that the average investor—in other words, the average human being who is gonna invest in the stock market, that the study we are going to be unpacking today has data for—has a really, really hard time ignoring their own psychology and buying and holding for the long term.

Instead, Dalbar, which is a company that studies investor behavior and investor market returns, which sounds hella fancy, found that average investors earn below-average returns. So here's an example. For the years between 1999 and 2019, the S&P 500 averaged 6.06% per year. This was mostly dragged down by the abysmal 2000 to 2009 returns after the dotcom bubble crashed and subsequent financial crisis in 2008. But the average equity investor did not get 6.06%. They only earned an annualized average return of 4.25%.

Big yikes. That substantially changes our projections for the future, right? That is a pretty dramatic departure from the types of metrics that we see tossed around online of, oh, you're gonna get 10% per year, because in that sense, your ability to get 10% annualized returns over the long run might actually have less to do with the economy or the stock market itself than it does with your own behavior. And I think the last 12 to 18 months have been a really, really solid test run for many of us who began investing during a raging bull market, like me, to see how we would react when the sky began falling.

Because stock market volatility is like turbulence on a plane: Even though your rational mind knows that the chances of something truly catastrophic happening are slim to none in the long term, when you are being tossed around like a crumb in a Pringles can at 35,000 feet, your rational mind is not the one that you're using. That's gonna take a backseat to your amygdala's fight or flight response. And it's really hard to reason through visceral fear, and hey, I am with you. I am truly, to my core, a neurotic overpreparer who also happens to have a fear of flying. So I'm nothing if not consistent. So I like to be conservative in my estimates.

For that reason, I use a 7% average return plus 3% inflation, for an average 4% annualized return in my Financial Independence Planner for all of my projections. That is a tab in the Wealth Planner, by the way. And I used to feel like I was being way too pessimistic, but now I feel like maybe that was a gut instinct that served me well. I don't know about you, but I would rather assume that I'm gonna do worse than average. So I am pleasantly surprised by overperformance if it happens, but there are other things that we can learn from this Dalbar research. So let's go a little bit further, because since 1984, 70% of underperformance occurred during only 10 key periods when investors withdrew their investments during periods of market crises.

So, translation: Vast majority of underperforming the averages happened during a handful of market crashes—events where people freaked out, they pulled their money out, and the narrative was that things were going to be no good, very bad for a long time to come. But, and this I found actually more surprising: 80% of the time, if an investor had simply held onto their money and done nothing, they would've gotten better results just one year later. So remember, that doesn't even assume that they were holding the S&P 500 or even another diversified large cap index fund, just that if they would've held literally whatever they were holding instead of selling it, they would've been better off 365 days later.

As for the scariest numbers I saw in the report, the 30-year return of the S&P 500 was 9.96% per year, which is where that 10% average number comes from that you'll hear tossed around. While the average investor over those 30 years got 5.04%. Bigger yikes. That halves the average that most of us personal finance fanatics use in all of our forward-looking projections, though, as a note, I will always advocate for diversifying beyond the S&P 500, including things like small cap value or international funds in your portfolio. Though that is a contentious recommendation; it's not an investment recommendation, just something that I think can help weather the storm. 

We’ll come back to that in a little bit, but let's get tactical. How do you not lose your money or your mind during these downturns? So by now, we probably understand that two things are true about the best ways to build wealth. Number one, owning a diversified set of index funds. And number two, holding them for the long term, aka, the boring and basic approach is probably the best way to build wealth without making large risky bets for most normal people. So here's the Money with Katie guide to not blowing your own lead and selling equities when shit hits the fan. And yes, it is simple in nature. Infomercial voice: Just three easy steps.

So number one, you're gonna build your portfolio the right way in the first place. We have seen so much investor euphoria since April 2020 when the market began that inexplicable rebound, and I guess it wasn't totally inexplicable. We can cue the money printing montage, where the Fed stepped in to help prop up the economy during the pandemic. And thank god they did. It became easy to forget during that time that stocks do not always go up. Until January 2022, when with every passing day we watched our gains evaporate before our eyes. 

But in that bull run, that post-pandemic period, people took on more risk because they assumed the reward was guaranteed. They kept super lean cash reserves, and in some cases, that's okay, if you have multiple sources of income, low expenses, small likelihood of emergencies—in other words, not a homeowner or a parent. You could probably get away with keeping a pretty lean safety net, but investing a down payment that you need in 90 days or putting your entire emergency fund into VTSAX? That was and is a recipe for, “Oh shit, the market is dipping. I need to get that money out now before it dips anymore because I need that money soon.” It stands to reason that your likelihood of pulling money out at the wrong time increases when you invest money that you should not be putting at risk in the first place.

So beyond keeping the right amount of cash on the sidelines to bolster your needs during downturns, investing in a diversified mix of index ETFs as opposed to just one, or a sampling of ETFs that have near-perfect correlation, will also help buoy your portfolio in downtimes and limit the extent to which you feel like you have to make changes in the moment. For example, when tech stocks got crushed, so think Facebook dropping 26% in a single day in February 2022 after a poor earnings report, it disproportionately impacts those large cap growth ETFs like those that track the S&P 500, because these cap weighted funds lean so heavily on the tech sector.

Now, that's normally a good thing since these tech companies are profit machines via monetization of your own precious attention. Yay. But it also illustrates how the fate of just a few companies that are typically impacted by the same market forces: regulation, sentiment, even, more or less dictates the fate of an entire fund, which is less yay and more nay. If you only own the S&P 500 or the S&P 500 plus cap weighted total stock market funds and large cap starts getting pounded, you are gonna feel that deeply. Pun intended. No pun intended? I don't know. The innuendos are starting to compound. And you're likely gonna feel more compelled during the downturn to diversify or sell than someone who is already diversified.

But much like the best time to buy insurance is before you need it, you are better off proactively diversifying and then making sure your portfolio is benefited by low-ish correlation. That's kind of hard to do these days, but you know, if you can, between the things that you own. So we've done an entire episode on building a diversified portfolio and indices that are worth considering. So we'll link that in the show notes for you. And at the end of the day, that's what this is about: navigating your own psychology and increasing the chances that you're gonna hang in there. 

I remember during the bleeding that was happening in 2022, there was a period when the small cap value that I owned was doing really well, despite how poorly the S&P 500 was doing. So I would log into my Copilot, I'd see all the different holdings; some would be red, some would be green, and seeing some green in my portfolio allocation helped me stomach all the red. Even though some of these funds have done worse overall than the S&P 500 in recent years, the primary benefit of owning them last year for me was that they were not doing poorly at the same time. And that, according to my personal investor philosophy, my assumption is that this is gonna lead to overall higher returns in the long run. 

Okay, so now that we've gotten proactive, we're gonna talk about two psychological strategies right after this quick break. 

Welcome back. We're moving on to number two. Remember that you still own the same number of shares. This is something else that helped me a lot during the 2022 correction era. Think about it this way: It is pretty disheartening to conceptualize tossing money into a bucket and then over time losing dollars in the bucket. That is scary. It activates that funky human and behavioral reaction of loss aversion, where we feel like we're losing money; we want to stop the pain. But if you imagine more accurately that you are exchanging that money for a piece of a company, aka a share, if you remember that you still own the same number of shares and that the number in your brokerage account with the dollar sign next to it is just the quick conversion of those shares into what they are worth right this second, it's, I think, easier to hang on and alleviate the feeling that you're losing anything.

So when prices start falling, paying attention to your number of shares instead, and reminding yourself that that number is the same can help. Then you wanna focus on getting more of those shares while they're priced lower than before. And that kind of gets to the point: that the number of shares is really the only metric by which you can fairly judge your own progress since the market being significantly up or down could give you a false sense of success or failure. It's pretty much outside of your control. If you owned a hundred shares of VOO in 2021 and now you own 120 shares, it doesn't matter if the quick shares-to-cash conversion is lower. Now you're still ahead because you own more shares of it. Now of course, this example does not work for things like meme stocks, but if you believe in the long-term viability of the US stock market as a whole, or large cap companies as a whole, and those are the indices or the index ETFs that you own, it stands up. 

And number three, embrace boredom and inaction. Now, this advice is cliche, but it is popular for good reason. It becomes more tempting to interfere and get creative when markets are going down. We feel like, okay, I have to be able to effort my way through this bloodbath, I should be able to identify trends, I should be able to get ahead of them. But the effects of missing the best days in the market are well documented. And I have talked about them before on the blog. So we're gonna link a very telling graph—please hum Nickelback’s “Photograph” softly to yourself now—from JP Morgan Asset Management analysis that demonstrates the absolute haircut you would've taken had you missed just the 10 best days in the market, assuming you owned the S&P 500 between 2003 and 2022. And because this is an audio show, not a visual one, I will describe it to you. Had you been fully invested over this 20-year timeline, you would've averaged 9.8% per year when annualized. If you had missed just the 10 best days over those 20 years, you would've averaged only 5.6% per year, which is pretty in line actually with our Dalbar numbers. And if you're like, yeah, but shouldn't it be relatively easy to not miss the best days? Like if I am pulling my shit out when it is tanking, how likely is it that I would quickly miss a best day? Turns out it is not easy at all. Seven of the 10 best days over those 20 years, seven of them occurred within two weeks of the 10 worst days. The second worst day of 2020 was followed the very next day by the second best day of the year.

In conclusion, it's funny because when I began investing in 2018, I figured all of the warnings about how tempting it would be to sell when things got rocky and how truly scary it would feel when things go sideways, I thought it was all hyperbole. And I always was warned in the books I was reading, the podcasts I was listening to, hey, there's this phrase you're gonna hear: “This time it's different.” And you know, that's never true, but you're gonna hear it. It's gonna feel true. And anyway, it always rang in my ears as something that only uneducated investors would fall prey to. 

But 2022’s crash was truly a, “Oh my god, this time it might be different” experience. We heard that over and over and over again. And by all measures, the stock market right now does not make literally any sense if you look at the world around it. Someone who pulled out expecting things to tank in 2023 was not stupid or ill-informed. They were just missing the fundamental truth of the stock market, which is that it can stay irrational far longer than you can stay solvent. And even as someone who thinks about personal finance constantly, I know these tropes like the back of my hand, I felt the fear. That fear was real. Doubt seeped in, and I felt the temptation to pull back and to stop adding more to the incineration that was happening inside my brokerage account. 

But as I told myself during this time, in order to limit your chances of getting nervous and blowing it, try to, number one, have the proper amount of cash set aside in the first place for your personal comfort, your expected purchases, and then diversify your investment funds proactively. Number two, remind yourself with excessive fervor that you still own the same number of shares when things are going down. In fact, if you need to stop tracking your net worth and dollars and start tracking in shares owned, try it. And number three, tattoo these charts about missing the 10 best days in the market to the inside of your arm and then reference it frequently. Maybe don't do this literally, but if you do, let me know. Send me an email. 

Realistically, when we project 10% average returns with 3% inflation for our portfolios, or a 7% average return if you're trying to control for inflation, though, you'll technically end up with slightly different numbers, outcomes, doing it that way. We have to remember that it is not outrageous to claim that our behavior determines the likelihood that we are gonna get that return more than the market itself does. So if you wanna use 10% returns, remember: You sacrifice your opportunity to earn those the moment that you start trying to hop in and out. If that is the strategy, create future projections using average 5% returns instead, as that's what the data tells us is more likely—and bonus, it'll hopefully serve as a deterrent for trying to time the market. 

All, right y'all. That is all for this week. I will see you next week, same time, same place, on The Money with Katie Show. Our show is a production of Morning Brew and is produced by Henah Velez and me, Katie Gatti Tassin, with our audio engineering and sound design from Nick Torres. Devin Emery is our chief content officer, and additional fact checking comes from Kate Brandt.