One topic in personal finance that is endlessly fascinating is why, in a country that has produced some of the greatest investing returns in the history of our nation, are so many people poor? It certainly isn’t a matter of investing skill.
Let’s say you put $10,000 in a low-fee index fund, like the Spartan® Total Market Index Fund — Fidelity Advantage Class, back in 2005. Looking at that investment through the lens of history, your timing was particularly bad. You only had that fund for two years before one of the biggest stock market crashes in history. Late in 2008 you watched your $10,000 dwindle to just $6,772, a gut twisting loss of 33%. Your friends shook their heads knowingly and reminded you that they told you that investing in the stock market was a bad idea; they laughed at you behind your back.
That’s a tough loss but, since you’re not a skilled trader, you just let your money sit in that same index fund. Today you look like a genius and your friends are no longer saying they told you so. That’s because that original $10,000 you invested in 2005 is today worth $22,714. Even including the devastating once-in-a-lifetime recession, you managed to average an 8.55% return over 10 years. Now you can afford to buy new friends.
In a country that is so fabulously wealthy, it is astounding that the bulk of market returns are flowing to a relatively small number of people. I just demonstrated that it doesn’t take any particular investing skill to get in on those returns, so what’s the problem? Even among people who do invest, the average returns are dreadful. It turns out our brains are not wired particularly well for investing. Our ancestors didn’t survive long enough to reproduce by taking the long view of investing and building for the future and our instincts are not well-matched with the modern world of investing. Instinct drives emotion and emotion is the great killer of investment returns. Here’s how emotion kills your investment returns.
Fear keeps you from investing in the first place; Fear nags at you every time the market goes through a rough patch. I guarantee you that every successful investor has dealt with the very same emotion. Fear was healthy for our ancestors; it kept them from taking unnecessary chances. Fear, unfortunately, is not a particularly useful emotion when it comes to personal finance. Learning to manage Fear is one of the biggest challenges of learning to invest.
Greed, as it relates to investing, is the polar opposite of Fear. Greed prompts you to try making a killing by investing in IPOs and other risky investments. Greed brushes aside caution, prudence and patience which are all necessary for successful financial management. Greed is every bit as irrational as Fear and the one most likely to devastate your finances. While Fear may keep you from being wealthy, Greed will wipe away what little you have.
Greed has a cousin and that cousin is named Envy. Envy is a relentless nag that’s never satisfied with what you have. Envy wants a new car, Envy wants to go to Cancun instead of taking a less expensive vacation closer to home. Envy wants clothing, shoes and jewelry like it sees in the magazines. Envy and Greed are kissing cousins that tag team your brain into making bad choices. What Envy wants, Greed says you can have. Envy won’t settle for living below your means so you can save and invest cash for your future. Envy doesn’t want to drive a sedan because it’s economical, Envy wants a status symbol SUV the size of Bangladesh apartment.
There are other emotions that play into investing but those are the big three. Everyone who has become a successful investor has learned to manage those three competing emotions. Being a good investor starts with the recognition that our brains are wired for short-term survival and not long-term investing.