The Investment Scientist

Wealth building tool: Automatic investments

Posted on: October 4, 2012

Like Odysseus, automatic investments help investors avoid the Siren call of market timing

We call it stupid if someone takes a $55k job, even if he is offered the same job at $100k.

We call it market-timing when the same thing happens in the stock market. The long-term average annual market return is 10%, but the long-term average annual investor return is only about 5.5%. This is documented both by Dalbar’s study titled “Quantitative Analysis of Investor Behavior” and Morningstar’s research on fund returns and investor returns.

How could this possibly happen?

As a financial advisor, I watch it happening all the time with my clients.

Most of my clients are doctors and business owners. They are very smart, hardworking and make a lot of money. I used to just tell them “write a check when you are ready to invest.”

I found out over the years that they would always write a check only after the market had run up a lot, thereby missing a large part of the rally.

If they had any worries about the market at all, they preferred to hold on to cash. Little did they know that economic worries are a necessary condition for good returns.

  1. Worries depress asset prices, meaning stocks are selling at a discount to their intrinsic value.
  2. Worries prompt governments to act, e.g., TARP.
  3. Worries prompt central banks to act, e.g., QEs.

Both TARP and QEs lift asset prices.

Our instinct is often self-defeating. Is there a way to prevent this from happening? The answer is yes.

Most brokerage firms and mutual fund companies allow so-called automatic investment. For Fidelity, it is called automatic account builder. What it does is pull a pre-determined amount from your bank account periodically and invest it.

Once automatic investments are put in place, the decision when and how much to invest no longer consumes your precious mental energy, and, most importantly, your instinct can no longer sabotage your investment.

To put it another way, setting up an automatic investment plan is not unlike Odysseus having himself tied to the mast when he sailed through the sea of Sirens. His act saved his life.

I am encouraging all my clients to set up automatic investments, and you should too.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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