Emotional investing can be costly

One of the biggest mistakes that investors make is to invest emotionally. Purchases often are made when the investor is the most certain and sold when the investor is the most concerned (or desperate).

If you think about it, that sets an investor up to buy high (most certain because they have seen it go up for a while) and sell low (they are desperate and without hope it will ever rise again).

There is considerable research on this subject. In the article “Quantitative Analysis of Behavior” published in 2005 by the research firm DALBAR Inc. it was determined that the S&P 500 earned an annual compounded return of 13.20 percent if you bought it in January 1985 and held it until December 2005. However, it was determined that the average investor only earned about 3.70 percent compounded annually for the same period.

I send out a weekly “Market Comment” via e-mail every Monday. Included in my article from April 24, 2006, was the following:

THE PENALTY FOR MISSING THE MARKET may be punitive. Historically, the market has gone up, and if you happen to be out of the market when it has some of its big up days, your return may suffer. For example, the following chart shows what your average annual return would have been if you missed some of the biggest up days for the S&P 500 Index over the past 30 years.

Average Annual Total Return

of the S&P 500 Stock Index 1975-2005

Fully invested — 12.6%

Missed 10 best days — 10.6%

Missed 20 best days — 9.1%

Missed 30 best days — 7.8%

Missed 40 best days — 6.6%

(Source: Ned Davis Research, 1/06 as reported by The Hartford. Individuals cannot invest directly into an index. Past performance is no guarantee of future results.)

It is tempting to look at the reverse and say, “What would happen if you missed some of the biggest down days for the market over this same period?” Not surprisingly, the returns would be much higher. Unfortunately, nobody has the ability to accurately time the market on a daily basis.

The best policy is also one of the simplest: It is time in the market, not timing, that counts.

Another study by the Center for Research in Security Prices for the period Jan. 1, 1994, to Dec. 31, 2003, showed the total return of the S&P 500 for the period as 11.2 percent compounded annually (2,519 trading days). If the 40 top trading days were missed, the returns were -4.1 percent compounded annually.

A quick story: I know about an investor (not one of my clients) who acted out the emotional ups and downs in the markets last year; we’ll call him George. George was nervous about the volatility that produced negative markets in May 2006. By the end of May he was ready to get out of the market and did so in June. Right after the move, the investments went up, and George felt the move was a mistake, so he decided to reinvest. Shortly after THAT move, the investments went down again, so he sold the investments again in July only to reinvest again in August.

The result of those moves were as follows: When he compared his performance to a similarly invested portfolio he discovered that the other investments that stayed invested produced almost 50 percent more return than his own for the 12-month period of 2006.

George has since stopped watching the markets on a minute-by-minute basis — and is a lot happier.

Think about your own investing. Did you get caught up in the dot-com boom only to ride the investments into the ground? If so, why did you ever invest in companies with no earnings that had so much speculation?

There is much research on this subject; suffice it to say that the best portfolio for you is one that achieves your goals while allowing you to remain patient and invested. The best thing you can buy with your investment allocation is PATIENCE.

Dale Terwedo, certified as a CFP, ChFC and CLU, is principal of Terwedo Financial Services LLC, an independent financial services firm in Edmonds. In practice since 1983, Terwedo offers securities and investment advice through FSC Securities Corp., Atlanta Ga., a Registered Broker/Dealer, Member of NASD/SIPC and a SEC Registered Investment Advisor. For more information, go online to www.tfsadvisors.com, send e-mail to retire@tfsadvisors.com or call 425-776-0446.

The views expressed are not necessarily the opinion of FSC Securities Corp. and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Investing is subject to risks including loss of principal invested. No strategy can assure a profit or protect against loss.