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Why do most people make poor investment decisions? I say that because most investors aren’t able to earn even the market rate of return?

People make poor investment decisions because they are human. We all come with mental software that tends to encourage us to buy after results have been good and to sell after results have been poor. So we are wired to buy high and sell low instead of buy low and sell high. We see this starkly in the analysis of time-weighted versus dollar-weighted returns for funds. The time-weighted return, which is what is typically reported, is simply the return for the fund over time. The dollar-weighted return calculates the return on each of the dollars invested. These two calculations can yield very different results for the same fund.

Could you explain that in some detail?

Say, for example, a fund starts with \$100 and goes up 20% in year 1. The next year, it loses 10%. So the \$100 invested at the beginning is worth \$108 after two years and the time-weighted return is 3.9%. Now let’s say we start with the same \$100 and first year results of 20%. Investors see this very good result, and pour an additional \$200 into the fund. Now it is running \$320 — the original \$120 plus the \$200 invested. The fund then goes down 10%, causing \$32 of losses. So the fund will still have the same time-weighted return, 3.9%. But now the fund will be worth \$288, which means that in the aggregate, investors put in \$300 — the original \$100 plus \$200 after year one — and lost \$12. So the fund has positive time-weighted returns but negative dollar-weighted returns. The proclivity to buy high and sell low means that investors earn, on average, a dollar-weighted return that is only about 60% of the market’s return. Bad timing is very costly.

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