Experience and research show that investors consistently act irrationally in managing their investments – buying and selling the wrong things at the wrong times and for the wrong reasons. For the young investor, the cost of these mistakes will never be known, since there is rarely a clearly defined goal against which to measure performance. But, for retired investors, the mistakes can be painfully costly since they can result in unexpected, and unpleasant, changes in lifestyle.

It would be interesting to see how different your investment decisions regarding your Thrift Savings Plan account might be if you had make-or-break performance standards to live up to. For example: You must achieve a 9 percent average rate of return over the next 20 years without suffering a loss of more than 10 percent in any one year, or you will have to reduce your spending in retirement by $5,000 per year, for life.

Lots of investors shoot for the 9 percent, or better, return, but ignore the importance of managing their accounts to avoid the unacceptable losses, which can, in spite of great returns, cost them dearly. Or, they’re obsessed with avoiding losses, and consequently ignore the need to achieve a rate of return adequate to support their needs.

While not the complete solution, the first step toward achieving great investment performance is to avoid these common irrational behaviors:

  • Trying to rectify losses after they have occurred. Nothing seems to motivate investors to act like losses. You’ve just lost a bundle of value and you feel inspired – maybe even compelled – to respond. The problem with this approach is that once the money is lost, it’s too late to do anything about it. The time to avoid a potential loss is before it occurs. Rational investors mitigate their losses before they occur, when asset values are rising.
  • Selling a fund because the price has fallen. Think about it: When is the best time to buy real estate? When the price is high or when it is low? If you own a home and prices plunge, is your first impulse to think about selling? Probably not. But investors think this way about their TSP funds. A strategy of selling
    the recent losers and buying the recent winners is even sold to investors by certain TSP “gurus.” The rational investor is interested in buying the losers, when their prices are low, and selling the winners, when their prices are high.
  • Avoiding funds because they have not performed well. I hear it all the time: “I don’t want to own [name any fund] because it hasn’t performed well.” I’ve heard this statement about every single one of the TSP’s funds at some point over the past 10 years. Every fund has had its time in the sun, and will again in the future. The problem is that it’s impossible to know when. The solution is diversification – to own all of the funds, all of the time. Diversification is the key to maximizing risk-adjusted returns – returns with minimal risk.
  • Refusing to sell a fund because it has done well. As a wise investor once said, “All good things must come to an end.” Because one fund has outperformed another in the recent past does not mean it will continue to do so in the near future. Investments ebb and flow, rise and fall. Whenever a fund is outperforming the others, a rational investor will consider selling it. The most reliable way to do this is to regularly rebalance your account to an appropriate allocation. This will have you selling some of the recent winners and buying the losers – a completely rational approach.
  • Defining performance in terms of return alone. If maximizing potential gain is your only objective, why not invest your money in lottery tickets? For most investors, the answer is that the potential for gain is not the only objective. In fact, for most investors, gain is not an objective at all. It’s a means to an end. The real objective is future cash flow – having the money you’ll need or want to spend, when you need or want it. To this end, in addition to gains in value, the predictability of realizing those gains is critical. In other words, it’s not just the potential rate of return that matters, but the likelihood of realizing that rate of return over a given time that counts. Often, an investor’s success is more dependent on avoiding losses than on realizing gains. This is the reason, for example, that owning bonds is so important – not for their ability to produce superior rates of return, but for their ability to mitigate the downside risk of the portfolio by tending to rise when stocks fall.

Written by Mikes Miles
For the Federal Times
Publication August 23, 2010