What's the best way for investors to play this market? That's a tricky one. Investors are facing instability in Europe, uncertainty in China and, now, unrest in Washington.
A recent survey by CNN showed that nervous investors, shaken once again by the recent political brinksmanship in Washington, are moving their assets from equities to cash. Individual investors are preparing to run from the dangers of the stock market, just as they did in 2009 and 2011; it's what we do every time uncertainty strikes.
We are far less prepared for a far bigger threat, however. Most investors don't realize the greatest threat that faces us during uncertain times: our brains.
How your brain is costing you money
In his landmark book on behavioral finance, Your Money and Your Brain, Jason Zweig explains how our minds often get in the way of making money. Rational impulses that made sense during human evolution, like running from things that frighten us or following the crowd, actually hurt us when it comes to investing.
One of the most fascinating studies in the book showed that individual investors not only lose to the market by nearly 10% on average, but they also don't know their results and often think they're beating the market when they're not!
I feel that Zweig's results highlight two fatal flaws that we all share.
Why we don't realize we're losing
First, we all feel that we are above average. In our minds, the very action of buying an individual stock means we're smarter than the person selling it. Yet so few of us actually track our performance objectively.
Why we lose to the market
Second, we lose to the market because "recency bias" forces our brains to use whatever has happened most recently in the market, or our portfolios, as our frame of reference for what will always happen. In short, we buy and sell at the absolute worst times, as this recent report by investment management company BlackRock (NYSE: BLK) illustrated.
Our overconfidence and recency bias haven't been lost on BlackRock's management as it decides the direction of the company. CEO Larry Fink said in 2011 that he would love to be "100% in stocks," and when commenting on the collapse of 2008, he noted: "If we went on holiday four years ago and came back better human beings with a tan, markets would still be back where they were four years ago."
Many investors who simply tuned out the noise and stopped trying to time the market, to Fink's point, are up big-time since 2011. Are you?
Tame your brain: Admit that it's hard
It's hard to admit how difficult it is to beat the market. Yet many investors who come to that realization make the costly mistake of turning to mutual funds.
It may surprise you that mutual-fund managers typically lose to the market when costs are included. After all, mutual-fund managers are people, too; they panic when the stocks they own sell off, and they often have a short-term focus because they feel the pressure of having an "off year." A recent report by Vanguard showed that between 1997 and 2012, only 18% of U.S. stock funds beat their benchmark index. And in the 1990s, the S&P 500 beat mutual funds, on average, by more than 3%. This means that for roughly the past 20 years, you would have been much better off investing in an index fund or sector ETF.
This is precisely what I recommend you do with the portion of your portfolio that you cannot afford to lose -- 80% is a good rule of thumb. By buying the "entire market," you may be less likely to sell into panic. If so, then buying index funds or ETFs will tame your brain and give you an advantage over the market.
Most index funds or index ETFs will do. I like the SPDR S&P 500 ETF (NYSEMKT:SPY) and, for dividend seekers, the SPDR S&P Dividend ETF (NYSEMKT:SDY). These funds are similar, but the SPDR S&P Dividend ETF offers a higher yield composite of the S&P at 2.7% versus the SPDR S&P 500 ETF's 2.2%. These funds hold stocks in sectors ranging from energy to basic materials to utilities. The dividend ETF holds high-yield heavyweights like ExxonMobil and Microsoft, but it limits its holdings to no more than 3% of any single stock.
Beat the market by following two rules
I feel this strategy of buying the entire market will allow you to beat the market -- not match it -- if you follow two simple rules:
- Do not sell into panic.
- Buy more when the market panics.
Check out this chart, which illustrates all of the ups and downs the S&P has experienced over the past 20 years. If you had the confidence to invest in the entire market, you may have been less likely to sell. Further, if you had bought during market panics, then you would have crushed the market's 12% historical return -- and you wouldn't have had to outsmart anyone. Simply buying index funds or index ETFs during a panic beats the market.
Don't "play" the market. Buy it.
I know what you're probably thinking right now: "Buy low, sell high -- that's not revolutionary." And you're right; it's not.
But how many of us actually follow that advice? From the research provided by BlackRock, Vanguard, and countless others, not many of us do. The truth is that we are all emotional. If we can temper our emotions and stay in the market through its darkest hours, we'll likely win. It's my opinion that buying "the market" instead of a single stock will calm your nerves when panic strikes. After all, while a single business may go bankrupt, there's little chance the entire market will go broke all at once.
By index-buying, you'll gain the confidence to buy more when the market falls and relax. In other words, you won't just think you're beating the market -- you'll actually beat it.
Adem Tahiri owns shares of SPDR S&P 500 ETF. The Motley Fool recommends BlackRock. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.