Investing is the most reliable way to build wealth over time. But most people fail to grow their money this way. Over the past 20 years, the average equity fund investor earned just 4.25% annual returns, compared to 10.4% annual returns for simply investing in an S&P 500 index fund.
This massive gap demonstrates that the average investor severely underperforms the market. Despite investing being a straightforward, mathematical process, human psychology causes most people to make poor decisions that cost them huge sums of money over time.
If you want to succeed at investing, you first need to understand the instinctive weaknesses built into our brains that sabotage your performance. Only once you recognize these pitfalls can you take concrete steps to counteract them. By simplifying your approach and removing emotions, you can harness the awesome power of the stock market to steadily build wealth.
Our Monkey Brains Are Programmed to Fail at Investing
Human brains evolved over millions of years to promote short-term survival, not long-term prosperity. In the wild, securing food might mean risking your life, so we learned to play it safe. Our “monkey brains” instinctively avoid risks, even if it means passing up a reward. This mentality served us well through the Stone Age.
But in the modern investing world, risk aversion causes terrible results. To grow your money over decades, you need to keep it invested through inevitable volatility rather than try to time markets. Our evolutionary programming makes this extremely psychologically difficult.
One famous investing thought experiment demonstrates this risk dilemma clearly:
Imagine three investors named Mr. Lucky, Mr. Unfortunate, and Mr. Consistent. Each starts with $1,000 and invests another $1,000 into the stock market at the start of every year for 30 years. The only difference is timing:
– Mr. Lucky miraculously invests at the very bottom of the market every single year
– Mr. Unfortunate does the opposite, buying at the peak every time
– Mr. Consistent simply invests on January 1st no matter what
After 30 years, how much money do you think each investor ended up with?
Instinctively, Mr. Lucky seems best positioned. By buying at the bottom, he is guaranteed that the remaining days that year will bring gains. Mr. Unfortunate seems doomed to fail by always investing at peaks.
But the results reveal our psychology’s flaws:
– Mr. Lucky earned 9.6% annual returns, turning $30,000 invested into $165,552
– Mr. Unfortunate still earned 8.7% annually, turning $30,000 into $137,725
– Mr. Consistent won with 10.2% annual returns, turning $30,000 into $187,580
This demonstrates that time in the market is far more important than timing the market. Mr. Consistent invested early and stayed invested all year, allowing compounding to work its magic. Mr. Lucky left cash on sidelines waiting to “buy the dip,” thereby missing out on gains waiting for the perfect moment.
Our risk-averse monkey brains focus on avoiding short-term drops, so we try to time markets. But missing out on time in the market is the greatest risk to returns. Resisting our instincts to stay invested pays off.
Herd Mentality Leads You to Buy High and Sell Low
Another destructive evolutionary instinct is herd mentality. In the wild, sticking with the crowd helped avoid standing out to predators. But when investing, following the herd leads to disastrous results.
When assets become popular and prices spike, our monkey brains tell us to jump in. This leads the herd to buy investments at all time highs after much of the upside has already occurred.
For example, Ark Invest’s Innovation ETF gained over 150% in 2021, far exceeding the broader market. This outperformance made headlines and attracted billions of dollars of new investment.
But now in 2022, Ark has come back down to simply match the market’s returns. Investors who piled in during the hype now face losses, whereas the earliest investors still gained substantially.
The same pattern holds true for formerly hot assets like Bitcoin and meme stocks. Prices skyrocketed after gaining viral hype and herds of new money flooded in. But ultimately, gravity caught up and brought valuations back down.
This leaves the late herd investors who bought into the hype and peak prices suffering losses. Letting FOMO drive decisions causes you to buy high after valuations have already shot upward.
On the flip side, when an asset falls out of favor and the herd starts panic selling to avoid further losses, you are inclined to join them. This drives prices down even further and causes you to “sell low.”
Following the crowd is a surefire way to buy high, sell low, and underperform.
Embrace the Boring Simplicity of Passive Index Investing
If our monkey brains are so terrible at investing, how can we possibly succeed? The answer lies in extreme simplicity and passive investing.
The hard truth is that reliably beating the market requires genius-level expertise, data analysis, and discipline. Investment legends like Warren Buffett and Peter Lynch are once-in-a-generation talents. You cannot expect to match their performance.
Here’s the good news: you don’t need to beat the market to meet your financial goals. The S&P 500 historically returns around 10% annualized despite multiple recessions and crashes. Thanks to compounding, those average returns create incredible wealth over decades.
You just need to harness that power by avoiding the psychological traps discussed above. Follow these steps to succeed through simple passive investing:
– Invest early and consistently – Start as soon as possible and keep contributing through ups and downs. Time in the market is what matters.
– Invest broadly – Use low-cost index funds to own thousands of stocks. Never try to pick individual winners and losers.
– Invest for the long term – Give your money decades to compound. Don’t tinker or try to time short-term swings.
– Automate it – Set up automatic contributions from every paycheck so discipline gets forced on you.
– Never panic sell – Volatility is normal, so steel your nerves and stick to the plan when markets drop.
This straightforward formula requires no skill or timing. It works by ensuring you remain invested through thick and thin so you never miss out on gains.
Passive investing won’t make you an overnight millionaire or impress people at parties. But it practically guarantees you will outperform the majority of investors over time by overcoming human psychology’s weaknesses.
While it lacks glamor, embracing the simplicity of passive investing allows you to reliably build wealth. Your future self will thank you for setting it and forgetting it. So stop trying to beat the market – it’s a fool’s game.
