The average investor likely has a less-exciting future than you do. You're poised to develop confidence in your investing skills, build wealth in your retirement account, and reach your financial goals. The typical investor, sadly, might struggle to generate wealth momentum over the long term.
Your financial future is brighter because you're about to learn four secrets to outperformance. And these secrets are way simpler than you'd expect.
1. You take market returns
According to a 2020 study by financial research company Dalbar, average investors earned about 5% annual growth in their accounts over the last 30 years. That's roughly half the average growth rate of the S&P 500 (^GSPC +0.25%) in the same time frame.
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To be fair, the performance gap between the average investor and the S&P 500 hasn't been quite as dramatic in recent years. In the three years ending on Dec. 31, 2019, for example, the average investor earned 11.5% annually, while the S&P 500 grew by 15.3% annually.
Still, the numbers are surprising because you can avoid lagging the S&P 500 index by 4% to 5%. If you invest in S&P 500 index funds, you should see performance that's only a fraction below the index.
Most of that fractional difference between the funds' performance and the index is related to funds' operating expenses. That's good, because it means you can minimize the drag of operating fees by choosing a fund with a very low expense ratio.
The SPDR Portfolio S&P 500 ETF (SPLG +0.27%) and Vanguard S&P 500 ETF (VOO +0.28%) are two examples. Both have expense ratios of 0.03%. SPLG's 10-year average annual return lags the S&P 500 by about 0.1% . The Vanguard ETF's 10-year average annual return is only 0.04% behind the S&P 500.
2. You stay calm
The Dalbar report finds that 70% of the average investors' underperformance occurred in volatile markets. Specifically, most of the investors who performed the worst sold their securities when the market was in crisis. Had they held on to those investments, they would have ultimately fared better.
The takeaway here is it's usually best to stay calm and stay invested. If you hold shares in an S&P 500 index fund, you own a portfolio consisting of the 500 largest and most successful public companies in the U.S. Most of these companies have a history of managing through turbulent markets, and then returning to growth. Generally, it's a good idea to trust that a dip in the value of your S&P 500 fund, or of any quality stock, is temporary.
3. Selectively, you do the opposite of the crowd
When everyone else is selling, it's often a good time to buy. You can turn a nice profit buying in a downturn, if you follow some best practices:
- Don't invest in a downturn unless your finances are in order. You should have an emergency fund and a balanced household budget.
- Don't expect a quick return. Market recoveries can take months or years. Be prepared for either timeline.
- Do invest in quality funds or stocks. A "quality" stock is an established company with low or manageable debt, experienced leadership, and consistent cash flows and profits. Such stocks often pay dividends, too.
Dividend payers can be good options because they should generate income as you wait for the recovery. Note that a mature organization might show a lower growth rate coming out of a down market versus a smaller company. But if the down market lingers, you should have more confidence the larger company will survive intact. That's a reasonable trade-off.
4. You buy and hold
The Dalbar report also concludes that a buy-and-hold strategy with the S&P 500 would have returned about $25,000 more than the average investor's portfolio between 2016 and 2019.
Buy-and-hold investing is the practice of investing in stocks and funds that you intend to keep for years or decades. The goal is to rely on the tendency for stocks to appreciate over longer periods of time.
To implement this approach, pick quality stocks or funds and hold them indefinitely. You might sell if the company changes in some fundamental way, but you won't sell because the market's having a temporary crisis.
Easier said than done
Hopefully, these four secrets to beating the average investor sound easy. They are, as long as you can resist making emotional decisions. The average investor can get anxious about market volatility, and that's often when shortsighted decisions are made.
If you tend to make emotional decisions, know yourself and plan accordingly. Write down your investment goals, exercise more, or meditate -- whatever it takes to stay calm, focused, and invested for the long term. Master that skill and you should beat the average investor. More importantly, you'll be stepping into a brighter, more empowered financial future.
