Over 20 years, the S&P returned 7.81% annually, but the average investor made only 3.49%.

The year 2012 was very good for investors. Despite all the negative news during theyear, the market, as measured by the S&P 500 Index finished up at 15.96 percent. As I write this article, the investor is still feeling pretty good as the S&P 500 nears an all-time high. However, as anyone who has folioed the market knows, this feeling can change in a heartbeat, forcing investors to face their fears and hopefully shut out the noise and stick to their financial plan.

“..it is ultimately the investor’s behavior and discipline that will determine success or failure.”

This financial plan can be accomplished with the many resources that are available to the individual investor. Browsing the Internet, the investor can find many financial calculators and software applications to help them plan their financial future. There are so many mutual funds and exchange-traded funds that I believe they outnumber the many individual stocks on the exchange.

Product, service and advice are everywhere for the individual investor, but it is ultimately the investor’s behavior and discipline that will determine success or failure.

In “The Investor’s Manifesto, Preparing for Prosperity, Armageddon and Everything in Between,” author William J. Bernstein lys out four essential characteristics all successful investors must have.

But even if investors possess the first three abilities listed in the book, “it will all be for naught if they do not have a fourth one: the emotional discipline to execute their planned strategy faithfully, come hell, high water or the apparent end of capitalism as we know it,” Bernstein writes in the preface.

As proof of this, DALBAR Inc., a market research company completes a study every year comparing investment returns with the average investor’s return. According to its April 2012 study, 2012 Quantitative Analysis of Investor Behavior, from 1992 to 2011, the S&P 500 Index returned an average annual return of 7.81 percent. However, the average investor achieved only a 3.49 percent average annual return during that 20-year period. And when you consider inflation, the average investor gained only .93 percent compared to a real return of 5.25 percent for the S&P 500.

The only explanation for these horrible results comes from investor behavior:

  • Chasing the latest hot area of investment
  • Selling at the wrong times, even though the investor’s goals remained the same
  • Stopping an investment program when the market his a slump
  • A combination of all of the above

More evidence of this is available at Morningstar’s website, which now tracks investor returns. Morningstar is an independent rating service that grades mutual funds with one to five stars based on past performance. In the performance section, you can view the funds return over a period of time and also the average investor returns through a “dollar-weighted return” calculation. This calculation takes into account buys and sells by the average investor.

What is amazing is the large variance among investor and investment returns of some funds. According to Morningstar, Fund XYZ had a 10-year annualized return through December 31 of 11.19 percent. However, the average investor return was -3.80 percent.

So if we think about this for a minute, we can put this into a real-life example. Let’s say an investor determined 10 years ago to invest into Fund XYZ. The investor who followed his or her plan would have enjoyed a return of 11.19 percent.

No doubt the bear market of 2008 would have been extremely painful but if the investor sticks to the plan, they’re still on board as markets rebound and rally back. Instead, many investors probably panicked, sold at the wrong time and ended up losing money. All the while, the investor’s goals did not change.

In my career, I have seen two horrible bear markets. Each has been different in what caused them, but they were the same in that they were impossible to predict. Absent an effective market-timing strategy that I am not aware of (or I would argue neither is anyone else), an investment plan matched to the investor’s goals will get the investor where they need to go.

But the investor’s discipline – not the market itself – is the most critical element to the plan succeeding.