Darren Winters - Extra

Unfortunately, our psychological biases and emotions are magnified when we try to outperform everyone else. We take foolish risks. The more successful we are in the beginning, the more risks we end up taking. Eventually, these risks come back to harm our wealth in the form of an investment blunder. Sooner or later, those investors going for broke end up getting there—broke. It is better to learn this lesson early. For example, consider the case of the early lesson. Here, the investor has some success beating the market and earning the 14% return. However, in year 5, a blunder occurs that wipes out 50% of the portfolio. At this point, the investor learns the lessons and just earns the market return for the remaining 15 years. This investor would have $612,000 at the end of the 20 years. Note that this is only half of the wealth dreamed about and two-thirds of the wealth that could have been acquired if the goal was to earn the market return all along.

The investor who learns the lesson midway through the time period is the mid lesson investor in the graph. This person has 10 years of success beating the market. He or she gets overconfident and starts taking more risk. In year 10, the investor experiences the blunder that decreases the portfolio by 60%. Note that the blunder loss is greater than that of the early lesson investor. This is because a longer period of success leads to greater risk taking and thus a higher potential for losses. After learning the lesson, the mid lesson investor ends up with $491,000. The late lesson investor experiences a 70% loss in the 15th year and ends the period with $373,000.
I should also note that many investors try to beat the market but never do. They chase last year's mutual fund winners. They try to time the market by jumping in and out of the stock market and specific stocks. They follow the advice of investment newsletters, analysts, and other gurus. The worst thing that many investors experience is that they always seem to underperform the market. That is, many investors don't experience one large investment blunder; instead, they experience many tiny ones. The investor that fails to earn the market return may earn only 10% per year. This active investor is also shown in the figure. Interestingly, experiencing yearly tiny blunders is better than experiencing one great blunder. The active investor ends the period with $680,000.

It may be that some investors can beat the market on a continuous basis and never experience a blunder. According to the figure, they would be greatly rewarded. The problem is that very few investors can do this. Some of those who do so are just plain lucky, not good. Ultimately, the pursuit of beating the market leads to investment blunders that seriously harm your wealth. Trying to seek the highest returns is dangerous business.

Consider the analogy of investors as members of Alcoholics Anonymous (AA). Out of 20 alcoholics, one may be able to eventually learn to be a social drinker again without becoming addicted again. If you were to tell the 20 members of AA this, each would likely think that he or she is the one who can do it and would give it a try. Our psychological biases make us overconfident and optimistic. As a consequence, most would try, and all those who tried (except one) would end up returning to their old habits. It would be better for the members to not try to become social drinkers. In investing, very few people can consistently beat the market. However, most of us believe that we are the one who can do it. In the attempt to outperform the market and our peers, we make foolish choices that open the door for an investment blunder. It only takes one blunder during your lifetime to seriously affect your wealth and your standard of living.
Thanks Darren Winters From Win Investing