Dumb Things Retirement Investors Do

My stomach sank when I read this headline: “Retirement Investors Flock Back to Stocks”. The article began with a declaration that should invoke fear in every market observer, “Retirement investors are putting more money into stocks than they have since markets were slammed by the financial crisis six years ago.” According to new data from Aon Hewitt, stock investments accounted for 67 percent of employees' new contributions into retirement portfolios in March, the highest percentage since March 2008. The article highlights a number of retirees, including one should be the poster child for why investors should avoid market timing. Roy put all his retirement assets into cash in May 2008 and over the past six years, has gradually increased his total stock allocation to 80 percent.

Let’s review that decision for a moment: Roy may have missed the worst part of the crash (the stock market bottomed in March 2009), but he also missed a good chunk of the stock market recovery. And I am doubtful that he employed a disciplined approach to rotating back into stocks. My guess is that he accelerated his stock purchases only after the market had gone up.

Economists call this “recency bias,” which means that we use our recent experience as a guide for what will happen in the future. So when stocks are soaring, we think markets will keep rising, but when the market plunges, we become convinced that it will never rise again.

Not surprisingly, the Aon Hewitt report underscores investors’ recency bias: At the stock market's peak in October 2007, investors put 69 percent of new 401(k) contributions into stocks. After the index lost more than half of its value over the next year and a half, frightened investors sharply reduced their allocation to stocks to 56 percent in March 2009, when the market hit bottom.

Over the past five years, the index marched higher and fear receded, allowing investors to slowly put money back into the market. Though as recently as last year, a whopping 76 percent of respondents told Bankrate.com that they were just saying "no" to stocks. Funny how a year of 30-plus percent returns can encourage retirement investors to rediscover their love of stocks!

This type of erratic investor behavior is actually quite common. Year after year, research from Dalbar analyzes the difference between how investor returns compare to major indexes and the news is not very good. According to Dalbar’s latest Quantitative Analysis of Investor Behavior study, despite some improvement, mutual fund investors have significantly underperformed the S&P 500 over the past 3, 5, 10 and 20 years. The average stock fund investor lagged the S&P 500 by 4.2 percentage points per year from 1994 to 2013.

Investors underperform for a simple reason: they jump in and out at the worst moments. Of course, only with hindsight do we understand that it was the wrong time. And sometimes, market conditions can lure us into thinking that nothing bad can happen. To wit, it’s been three years since the S&P 500′s last correction began. Since the summer of 2011’s 19.9 percent swoon, the S&P 500 has not experienced a correction of more than 10 percent. Sure, there have been pullbacks (the most extreme of which was the 9.9 percent drop in the Spring of 2012), but none of which lasted long enough to spook investors.

Nobody knows when the next correction is coming, but rest assured, it will arrive at precisely the wrong moment. Investors can protect themselves from the insidious trap of buying high and selling low by diversifying their portfolios, which can help them avoid doing dumb things with their money. As Benjamin Graham, the founder of security analysis, said in his 1949 masterpiece, The Intelligent Investor. “The investor’s chief problem – and even his worst enemy – is likely to be himself.”