Over the weekend, I was doing some research and stumbled across an article my friend Cullen Roche wrote a couple of years ago entitled “Can we All Agree to Stop Comparing Everything to the S&P 500” in which he stated:

“Benchmarking is a pernicious thing in financial circles. Not only because it disconnects the way the client and a fund manager understand the concept of ‘risk’, but also because the concept of benchmarking seems to be misunderstood.”

He is right. Risk is rarely understood by investors until it is generally too late.

Take, for example, a call I received the other night during a broadcast of the “Real Investment Hour” The caller did not understand why I was discussing the importance of “risk management” when he was doing so well just investing in “index funds.” I then asked him a question:

“When did you start your investing journey?”

When he proudly exclaimed that he had been investing for almost 6-years, the problem became readily apparent. Since he had never been through a severe corrective market, the concept of “loss,” and ultimately the need for “risk management,” was a foreign concept. It was the equivalent of trying to explain how a car works to someone who had never seen one.

The chart below is an inflation adjusted return of $100,000 investment in the S&P 500 from 1990 to present. The reason that 1990 is important is because that is when roughly 80% of all investors today begin investing. Roughly 80% of those began after 1995. If you don’t believe me, go ask 10 random people when they started investing in the financial markets and you will likely be surprised by what you find.

investor-psychology-100k-103016

As shown, there is certainly a case to be made for buying and holding an index. However, it is quite clear that “buying low” and “selling high” would have been much more beneficial from 2000 until present. (I have also noted the points in past history where the “wisdom of crowds” have formed to “buy into” really bad ideas.)

Unfortunately, investors rarely do what is “logical,” but react “emotionally” to market swings. When stock prices are rising, instead of questioning when to “sell,” they are instead lured into market peaks. The reverse happens as prices fall. First, comes “paralysis,” then “hope” that losses may be recovered, but eventually “capitulation” sets in as the emotional strain becomes too great and investors “dump” shares at any price to preserve what capital they have left. They then remain out of the market as prices rise only to “jump back in” about mid-way to the next market peak.

Wash. Rinse. Repeat.