There are several explanations for this outcome. The first is that investors allow their emotions to impact their investment decisions. In bull markets, greed and envy take over and risk is overlooked. In bear markets, fear and panic take over, and even the well-thought-out plans can end up in the trash heap of emotions.

The second explanation is that investors are overconfident of their ability to deal with risk when it inevitably shows up. They believe that they can stomach losses of 20, 30, 40 or even 50 percent and still stay the course, adhering to their plan. However, the evidence demonstrates that investors are as overconfident of their investment abilities as they are of their driving skills (studies have found that the vast majority of people believe they are better than average drivers).

The third explanation is that investors often treat the likely (stocks will outperform Treasury bills) as certain and the unlikely (a severe bear market) as impossible. The result is that they take more risk than is appropriate-and when the risks show up they are "forced" to sell.

The Keys To Successful Investing

There is an old adage that "those who fail to plan, plan to fail." Therefore, the first key to successful investing is to have a well-thought-out plan. That plan includes an understanding of the nature of the risks of investing. That means accepting that bear markets are inevitable and must be built into the plan. And that means having the discipline to stay the course just when it will be most difficult to do so (partly because the media will be filled with stories of economic doom and gloom). What is particularly difficult is that staying the course does not just mean buy and hold. Adhering to a plan requires that investors rebalance the portfolio, maintaining their desired asset allocation. That means that investors must buy stocks during bear markets and sell them in bull markets. That brings us to the second key to success.

While academic research has determined that almost all of the risk and return of a portfolio is determined by the portfolio's asset allocation, the actual returns earned by investors are determined more by the ability to adhere to whatever the allocation they chose than by the allocation itself. Thus, the second key to successful investing it to be sure that investors do not take more risk than they have ability (determined by their investment horizon and stability of income), willingness (risk tolerance) and need (the rate of return needed to achieve their objectives) to take. Those investors that avoid excessive risk taking are the ones most likely to be able to stay the course and avoid the buy high/sell low pattern that bedevils most investors.

The third key to success is to understand that trying to time the market is a loser's game. A loser's game is one that while it is possible to win, the odds of doing so are so low that it is not prudent to try. Consider the evidence from two studies on market timing. Tactical Asset Allocation (TAA) is just a fancy name for market timing. For the 12 years ending 1997, while the S&P 500 Index on a total return basis rose 734%, the average return for 186 TAA mutual funds was a mere 384%.² Just as impressive is the results of a study on the performance of 100 pension plans that engaged in TAA: Not one single plan benefited from their efforts.³ If the results of these studies are not enough to convince you, perhaps the following from legendary investor Warren Buffett will. Listen carefully to his statements regarding efforts to time the market:

• "Inactivity strikes us as intelligent behavior."⁴
• "The only value of stock forecasters is to make fortune-tellers look good."⁵
• "We continue to make more money when snoring than when active."⁶
• "Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient."⁷

1 | 2 | 3 | 4 |