Behavioral Finance Mistakes That Hurt Your Portfolio and What “Good” Returns Look Like

Summary

NerdWallet's Smart Money Podcast: Behavioral Finance Mistakes That Hurt Your Portfolio and What “Good” Returns Look Like

Episode Release Date: February 24, 2025
Hosts: Sean Pyles, CFP®, Sara Rathner, Elizabeth Ayola
Guest: Johannes Harrison, Behavioral Financial Advisor and Founder of MoneyScript Wealth Management
Money Question Expert: Sam Taub

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Introduction

In this compelling episode of NerdWallet's Smart Money Podcast, hosts Sean Pyles and Elizabeth Ayola delve into the intricate world of behavioral finance, exploring common mistakes that can hinder investment portfolios. With insights from Johannes Harrison, a seasoned behavioral financial advisor, and a practical money question segment featuring Sam Taub, listeners gain a comprehensive understanding of how psychological biases impact financial decisions and what constitutes “good” investment returns.

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Understanding Behavioral Finance Mistakes

Behavioral finance examines how emotions and psychological factors influence individuals' financial decisions, often leading to irrational outcomes. Sean Pyles sets the stage by acknowledging the brain's role in sabotaging financial goals:

"Sometimes your brain can be your own worst enemy when it comes to making progress on your financial goals." – Sean Pyles [00:00]

Johannes Harrison elaborates on this by introducing key behavioral biases:

1. Cognitive Dissonance and Anchoring [02:22]

   • Cognitive Dissonance occurs when conflicting beliefs coexist, such as being excited about a stock's potential while simultaneously criticizing the company's products.
   • Anchoring involves relying too heavily on the first piece of information encountered. For instance, seeing a house listed at $700,000 makes a subsequent offer of $650,000 seem like a bargain, even if it's not based on the home's true value.

     "Investors do this with stocks all the time. Sometimes someone will buy a stock after their friend tells them how much money they made, and then the price drops..." – Johannes Harrison [03:50]

2. Recency Bias [04:58]

   • This bias leads individuals to believe that recent market trends will continue indefinitely. A booming market may convince investors it will never decline, while a downturn can instill a belief that it will persist.

     “Recency bias is when we assume that what is happening is going to happen forever.” – Johannes Harrison [04:58]

Elizabeth Ayola emphasizes the prevalence of these biases in investing:

"This kind of behavioral bias can be seen across the range of interactions that people have with money. But some of the ones that cost us the most pop up in investing." – Elizabeth Ayola [04:06]

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Strategies to Overcome Behavioral Biases

Johannes Harrison provides actionable strategies to mitigate the impact of these biases:

1. Zooming Out and Focusing on Fundamentals [04:52]

   • Instead of fixating on fluctuating prices, assess the intrinsic value based on fundamental analysis.

     "The key is zooming out. Instead of focusing on the prices, ask yourself what's the value today based on real fundamentals." – Johannes Harrison [04:52]

2. Long-Term Planning and Emotional Detachment [07:17]

   • Emphasizes the importance of maintaining a long-term perspective and not letting emotions dictate investment decisions.

     "Investing is not supposed to be exciting. It's supposed to be like watching paint dry." – Johannes Harrison [07:17]

3. Adopting a Well-Defined Plan [09:56]

   • Creating and adhering to a structured investment plan helps counteract impulsive decisions driven by emotional responses.

     "Have a well defined plan and sticking to that plan in light of all of the information that will be coming to you." – Johannes Harrison [09:56]

4. Utilizing Robo Advisors [12:54]

   • Robo advisors can help maintain discipline by automating investment decisions based on predefined criteria, thereby reducing the influence of emotions.

     "Robo advisors and algorithms can also help you from getting into trouble with allowing your emotions and thoughts get in the way." – Johannes Harrison [12:54]

Personal Anecdote [15:25] Johannes shares a personal experience with recency bias when his robo advisor sold a stock that subsequently soared:

"I recently had a stock that was sold out of my portfolio because of my robo advisor... I can't believe I sold that stock. It just hit an all-time high in the news." – Johannes Harrison [15:25]

He reflects on the importance of maintaining a long-term strategy despite short-term fluctuations.

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Money Question Segment: Evaluating Investment Returns

Listener Inquiry: Mary reached out with concerns about her investment growth:

"I have about $6,000 in my Wells Trade IRA and around $3,000 in my Wells Trade account. Since 2018, my $1,000 contribution has grown to about $2,000. Is that a decent return?" – Mary's Question [19:15]

Expert Response by Sam Taub:

1. Assessing Returns [20:35]

   • The S&P 500 averages a 10% annual return before inflation over the long term. Mary's 100% growth over seven years aligns closely with this average but is slightly below the market's typical performance.

     "The S&P 500 has returned about 10% per year before inflation on average." – Sam Taub [20:35]

2. Understanding Mutual Funds [22:15]

   • A mutual fund is a diversified investment vehicle managed by professionals, offering exposure to various stocks and bonds.

     "A mutual fund is just a publicly traded basket of stocks or other investments like bonds." – Sam Taub [22:15]

3. Optimizing Investment Strategy [23:42]

   • If Mary seeks higher returns and is comfortable with increased risk, switching to a more aggressive mutual fund or an index fund like the S&P 500 could be beneficial. Index funds typically have lower fees and better align with long-term growth objectives.

     "Switching to an index fund like that is probably a pretty cheap and easy way to accomplish the goal of getting more aggressive and seeking higher returns." – Sam Taub [23:42]

4. Tax Implications [24:49]

   • Moving funds within retirement accounts like IRAs avoids capital gains taxes, whereas adjustments in taxable accounts may trigger tax liabilities.

5. Aligning Investments with Goals [25:23]

   • Understanding Mary's investment timeline and objectives is crucial. For longer-term goals, adopting a more aggressive strategy can leverage market growth while mitigating short-term volatility risks.

     "If Mary's investing for a longer term goal than that, then her investment would probably have plenty of time to recover from a bear market." – Sam Taub [25:23]

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Conclusion and Key Takeaways

This episode underscores the profound impact of behavioral biases on investment decisions. By recognizing and understanding biases like anchoring and recency bias, investors can adopt strategies to maintain a disciplined, long-term approach. Utilizing tools such as robo advisors and aligning investment choices with personal financial goals further enhances the ability to navigate market fluctuations effectively.

Final Advice from Johannes Harrison:

"Recognizing that those emotions are real and asking yourself the question, am I about to make this decision based on my emotions, or am I making decisions based on facts and fundamentals?" – Johannes Harrison [10:27]

Listeners are encouraged to educate themselves on behavioral finance, develop a robust investment plan, and seek professional guidance to optimize their financial strategies.

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Stay Connected:
For more personalized financial advice and to ask your own money questions, contact NerdWallet’s Smart Money team at 901-730-6373 or visit NerdWallet’s Smart Money Podcast.

Transcript

[Sean Pyles]

Sometimes your brain can be your own worst enemy when it comes to making progress on your financial goals.

[Elizabeth Ayola]

Whether it's keeping your impulse spending in check or sticking to your investment strategy, it's all too easy to get in your own way and do things that aren't in your best interest.

[Sean Pyles]

This episode will help you overcome at least one self imposed roadblock so you can make smarter money moves. Welcome to NerdWallet's Smart Money podcast where you send us your money questions and we answer them with the help of our genius nerds. I'm Sean Pyles.

[Elizabeth Ayola]

And I'm Elizabeth Ayola. On this episode, we answer listeners question about what kind of returns they can expect from their investments.

[Sean Pyles]

But first, I want to share an exciting update. Longtime listeners have heard Elizabeth join me on the podcast many times over the past few years, but I'm thrilled to announce that she is officially moving into a new role as my full time co host on Smart Money. For folks wondering, we will still have Sarah Rathner join us on the pod occasionally too, but hey Elizabeth, welcome to the hosting seat.

[Elizabeth Ayola]

I'm so excited to be in the co hosting seat. And listeners, my hope is that you aren't throwing virtual tomatoes at me. I plan to give it my best. I love talking about money and it's an honor to help people navigate their financial decisions.

[Sean Pyles]

And folks might have noticed that we also have a pretty snazzy new logo for Smart Money. We're always learning and growing here at Smart Money and sometimes that means getting a fresh co host, getting a fresh logo, and mixing things up.

[Elizabeth Ayola]

For anyone out there who's wondering what the heck we're on about, our new logo is neon green in case you're looking for us inside of your podcast app. And while you're there, don't forget to leave a review.

[Sean Pyles]

Yes, hopefully a positive one. All right, well, let's get on with the show. To start things off, we are talking about some of the behavioral biases that can get in the way of a good investing strategy. And these are biases that anyone can exhibit regardless of their experience. Joining us to talk about this is Johannes Harrison, a behavioral financial advisor and founder of MoneyScript Wealth Management. Johans, welcome to Smart Money.

[Johannes Harrison]

Thank you. Good to be here, Sean. Elizabeth, congratulations.

[Elizabeth Ayola]

Thank you, Johance. I appreciate that.

[Sean Pyles]

So let's start with a Little Behavioral Finance 101. In essence, behavioral finance is an economic theory that describes how people make decisions about their money based on emotions or psychology rather than acting in a purely rational way. So can you give us a couple of examples of what that looks like.

[Johannes Harrison]

I'd love to, Sean. Let's start the stage with something in behavioral finance we like to call cognitive dissonance, which is when you have two conflicting beliefs that live in your brain at the same time. For example, have you ever been excited about a stock to go up while at the same time complaining about the prices of the products or services of the company that makes it?

[Sean Pyles]

Yeah, that's a good one.

[Johannes Harrison]

That's exactly what's happening in our brain. And that leads to what we refer to as anchoring and recency biases. They are primary contributors to us having this conflict in our mind. And. And they lead to a chicken or egg sort of paradox where one can lead to the other and the other can then lead right back to the same one. So let's start with anchoring. Anchoring is when the first number you see influences your decision, even when it shouldn't. So imagine if you're driving through a neighborhood and you see a new development of houses and the sign says new home starting at $700,000. A few months later, you decide to take a look at one of the homes, and the builder says, there's a special on that home for $650,000. All of a sudden you'll start to feel like you're getting a deal because.

[Sean Pyles]

You expected it to be more expensive. So all of a sudden, because of basically a trick of marketing, you think you're getting a fantastic deal on this new home.

[Johannes Harrison]

Exactly. And investors do this with stocks all the time. Sometimes someone will buy a stock after their friend tells them how much money they made, and then the price drops, and then the new investor refuses to sell because they're anchored to that original price instead of the stock's actual value.

[Elizabeth Ayola]

So this kind of behavioral bias can be seen across the range of interactions that people have with money. But some of the ones that cost us the most pop up in investing, since we're on the topic of investing. So what kinds of behaviors of these sorts do you see investors fall into Johans?

[Johannes Harrison]

I see the anchoring effect can cause a bit of buyer's remorse. Following the COVID 19 epidemic, the S&P 500 rallied double digits for 2020 and 2021, and investors just piled into equities. However, 2022 brought a double digit drop in the S&P's value, and many investors weren't prepared for this level of volatility. Now we have to think about how can we fight anchoring? Because it's hard to ignore the first number that we see. And the key is zooming out. Instead of focusing on the prices. Ask yourself what's the value today based on real fundamentals. And the same thing goes with real estate shopping, anything. Don't get hypnotized by the first number. Look at the big picture and consider the purpose of the investment. And when I say purpose, what goal are you actually investing for?

[Sean Pyles]

So I want to turn and chat a bit about recency bias. You mentioned that before. Can you define that for us?

[Johannes Harrison]

Recency bias is when we assume that what is happening is going to happen forever. So when the market's going up, we think that the market will keep going up. And when it's going down, we feel like it's going to go down forever. And like I said, it's one of those chicken and egg sort of syndromes where the first bias that we have with anchoring can then lead to the recency bias bias. Like I mentioned earlier, with the democratization of investing that happened during the pandemic, lots of new investors were entering the market and the market was rallying. As those investors got into the stock market, especially those that got in later in 2021, they thought the market only goes up. And the same was even true for cryptocurrencies during the same timeframe. Then in 2022 when prices were going down, those same investors panicked and newer investors thought that the market only went down. The same thing happened in the 0809 recession, going back to the dot com bubble in the early 2000s. We're constantly focused on what happened and think that's always going to happen instead of again pulling back and looking at the big picture.

[Elizabeth Ayola]

I guess I have a question around how people can do that. So what does it look like in practical terms? I guess like we say explain it to a five year old to look at the big picture, especially for new investors who are maybe not well versed in that.

[Johannes Harrison]

Looking at the big picture is recognizing that the market goes through cycles, they go up and down. It's volatility is the price we pay for the returns in the stock market. So you want to look again at the long term of what are you investing for. So if you're a brand new investor and let's say you're starting your 401k or some sort of IRA, think about when you expect to use that money and allow that information to guide your investment decisions. Also, don't get emotional about what's happening in the market. Again, it's going to go up, it's going to Go down. That's part of investing. And know that once, about every two years, the market's going to have a 10% decline. That's just normal. That can also present a great time to start investing, especially if your outlook is long term. The longer you hold those investments, the greater the likelihood that you're going to have positive returns.

[Sean Pyles]

And what you've just described is why a lot of financial advisors will often recommend that you don't invest money that you will need within five years so that it has enough time to grow and weather ups and downs. Because over the long term, the market has gone up historically, but you want to have enough of a time cushion so you can get that long term growth.

[Johannes Harrison]

Exactly. And again, detach your emotions from it. There's an old saying that investing is not supposed to be exciting. It's supposed to be like watching paint dry. Nothing happening here. Just put your money in. Think for the long term. Don't allow your emotions to change your involvement in how you're going to invest. In other words, I'm going to say it really simply have a plan, stick to that plan and just keep moving forward.

[Sean Pyles]

But Johans, a lot of people now treat investing like a game on their iPhone because for a lot of folks, that's what it has really become for them through certain apps that they're using.

[Johannes Harrison]

That's true. And remember, if you're going to treat it as a game, the game is to win. Not today, not tomorrow, but as you stated earlier, at least five years from now. So if you can keep that long term outlook and stay in the game, similar to how I taught my son to play Monopoly, the goal is to stay in the game longer than everyone else rather than blowing all of his money the first time he goes around the board and then he can't stay in. So staying in the game is the game.

[Elizabeth Ayola]

So how much do you think a knowledge of how the stock market works plays into these biases? So I know for me, because I factually know, like you said, the rate of return or average rate of return on the stock market is 10%. I don't worry too much about that. So do you think it's a lack of understanding of how the stock market works that kind of drives that fear and maybe elucidates the biases as well.

[Johannes Harrison]

It's not so much the lack of understanding how it works because like you said, a lot of people understand that the have heard that the stock markets can return positive returns close to the area of 10% over time. It's Our emotions that get in the way. If you go into investing with the thought, okay, the stock market gets a 10% return. And then like in 2022, you lost 20% of your money in the first year. So that emotion, that feeling of, oh, why did I do this? This was a bad decision, I'm losing. And that's where the recency bias starts to creep in. It's going down. It's always going to go down. It's never going to go back up. Removing that emotion and saying, no, this is a part of it. My way to 10% is accepting this negative 20% and continuing to stay invested and continuing to invest and remembering things like some of the greatest investors of all time have taught us. When other people are being fearful is a great time to be greedy. And when other people are being greedy is a great time to be fearful, a la Warren Buffett.

[Sean Pyles]

These kinds of biases seem to be a part of who we are as people. They're really kind of ingrained into our humanity. So I'm wondering how you think people can become more aware of their behavioral biases and maybe actually try to counter them to minimize any sort of financial losses.

[Johannes Harrison]

One of the best things you can do to help counter these biases is learn what they are. And the number one way that every professional on this topic is going to tell you is to have a well defined plan and sticking to that plan in light of all of the information that will be coming to you. Another thing to do is sometimes you just have to turn the TV off and get rid of the noise because the noise can distract us. The noise may not be the television may be coming on our phone, it's coming in social media, it's coming from friends. But that noise gets in the way of what your long term goals are and sticking to that plan over time. The last thing I'll say is that we're all familiar with the phrase of when we're encountered by fear that we may want to go into what's known as fight or flight syndrome. And there's actually some new data that's come out about the fight or flight response. And there's another response that we also need to pay attention to, which is just doing nothing, freezing. We don't have to fight the bear, we don't have to run from the bear. Actually, if we're just really, really still, maybe the bear will just go on about its way. Think about that. When it comes to a bear market, when it comes to bull markets, we don't have to fight Them, we don't have to run from them. Sometimes the best thing to do is just to stay the course and not do anything different. So recognizing that those emotions are real and asking yourself the question, am I about to make this decision based on my emotions, or am I making decisions based on facts and fundamentals? And if you're leading back to the emotions, you're probably not making the best financial decision.

[Elizabeth Ayola]

I'm also curious about what role money fears play in this type of behavioral bias also. So, for example, is someone with money fears, or even financial trauma, let's say, around losing all of their money, more prone to impulses that come with the bias?

[Johannes Harrison]

Absolutely. And actually, a good friend of mine, Dr. Daniel Crosby, I may be paraphrasing this a bit, but he said one of the greatest risks that we can take is not taking risk at all. So these money fears that we have, fear of losing, fear of getting it wrong, fear of messing up, can actually stall us from getting started. If you look back, there's lots of data on this, on how investors reacted after the financial crisis of 2008 and 2009. And during that time period, many investors sat on the sidelines in fear of investing and missed out on one of the greatest bull markets that we have ever seen in the stock markets, especially here in the United States. So, again, that fear of not being able to be in control of what's happening can cause some inaction. And the best thing to do is maybe talk to a professional, find someone that is a financial advisor or behavioral financial advisor that can talk to you about your goals, talk to you about your feelings, and then educate you and help you put together a plan to get you back on track.

[Sean Pyles]

I'm wondering if you could talk about the role that robo advisors can play in keeping us from making these kinds of decisions and sometimes mistakes. Because algorithms don't have recency bias, right? Although they may have other biases.

[Johannes Harrison]

Here's what we have to remember about algorithms is that they were built by a person. So someone wrote that code. And another friend of mine, Ted Truscott, he said to me one day about algorithms is that they all work until they don't. What he meant is that the algorithms, they don't have recency bias, but they also, with that receive bias comes new information. The algorithms did not understand the COVID 19 breakdown of 2020. The algorithms didn't quite understand when there was other things that were happening in the world and in the economy that were directly affecting the stocks that day. And sometimes the algorithms can cause excessive trading that will happen where in some cases the people that run the stock market will shut things down and say, no, we gotta stop this. However, those same robo advisors and algorithms can also help you from getting into trouble with allowing your emotions and thoughts get in the way. The fundamentals of what's happening with the underlying stocks and investments that you're working with. And quite frankly, 80% of the money that I manage for clients is on some sort of robo advisor type platform, meaning I've set barometers of where I want to buy and sell certain securities. When it goes outside of that barometer, either I get an alert or for some accounts, depending on how they're invested, it may automatically trade so that I don't have to think or allow my emotions to get in the way of the long term plan for that portfolio.

[Sean Pyles]

But to your point earlier, you have followed and established a plan. You know what your client's risk tolerance is, what their time horizon is, and you can tune out the rest of the noise in the meantime, as long as you're making regular progress based on your own parameters.

[Johannes Harrison]

You're absolutely correct. And I have to come in as a human every now and then and make certain tweaks to that algorithm because perhaps my clients lifestyle has changed, perhaps their goals have changed, perhaps their job has changed, perhaps tax rates have changed. So those changes do require us as humans to go and make some tweaks to those algorithms and robo advisors. But for the most case, they're a great place to start for someone that's just getting started, looking to get into investing. A robo portfolio or some sort of self managed portfolio can often be better than trying to pick the hot stock of the day.

[Elizabeth Ayola]

So I know that you're a finance pro, but I have to ask you Johannes, have you ever found yourself engaging in either recency bias or some other element of behavioral finance where you said to yourself, wait, this is my brain reacting in a way that may not benefit me in the long run. And if you did, how did you react to that realization?

[Johannes Harrison]

So I have a very recent recency bias situation. It also involves a little bit of anchoring because again it's, they kind of lead to each other. I recently had a stock that was sold out of my portfolio because of my robo advisor that I had on my own personal portfolio. And when it sold and I saw, and I didn't see it to after the fact because I let the robo do its thing and it sold and I said, oh my goodness, I can't believe I sold that stock. It just hit an all time high in the news. They're talking about it doing a split. Last time I did a split, it went up by 200%. Why did I sell it? And then I remembered that I paid three times less for it. I sold it because I made money. And my algorithm said, you're overweighted in this now, so we're going to sell.

[Sean Pyles]

That's so interesting.

[Johannes Harrison]

But it was a little painful, too. And it was one of those companies where I'm frustrated because they keep raising the price of the service, but meanwhile the stock price is going up. So I'm like, why am I complaining here?

[Sean Pyles]

That makes me think about how people often forget that one of the goals of investing is to buy low and then sell when it gets high. That second part, people just think they want to hold onto it forever. But no, at a certain point you want to cash it in.

[Johannes Harrison]

The only way to make money is to eventually sell. It's not really made until you sell and it's turned into cash that then you can use to purchase something else or for your lifestyle or what have you. Until then, the gains are, as they say, just on paper.

[Sean Pyles]

Johan Tarasen, thank you so much for joining us.

[Johannes Harrison]

Thank you, Sean, Elizabeth, it was wonderful to be here.

[Sean Pyles]

All right, we're about to get into this episode's Money Question segment where we answer a listener's question about what kinds of returns they can expect from their investments.

[Elizabeth Ayola]

But before we get into that, we're at that special part of the show, the moment where we ask you to take a minute and think about where you need some nerdy guidance with your money.

[Sean Pyles]

Maybe you're wondering how to shake other behavioral biases that are leading you to make bad financial decisions, or you're in the middle of planning a vacation and want some help maximizing your points game. Whatever your money question, we nerds are here to help. Leave us a voicemail or text us on the Nerd hotline at 901-730-6373. That's 901-730-N E R D. And a.

[Elizabeth Ayola]

Reminder that one of our goals on Smart Money this year is to talk with more of you live on the podcast to help you with your money questions. Yes, we want to hear your voice. So if you want to hang with Sean and me for a bit and get some nerdy wisdom, let us know one more time. Leave us a voicemail or text us on the Nerd hotline at 901-730-6373. That's 901-9730. Nerd.

[Sean Pyles]

Alright, let's get to this episode's Money question segment. That is up next. Stay with us. Today's episode is supported by Range Rover Sport. Some things in life demand a second thought, like choosing the right financial advisor or deciding whether to trust a restaurant with no reviews. But when it comes to driving, you should never have to second guess your ride. That's why there's the Range Rover Sport. With a dynamic, sophisticated take on sporting luxury, the Range Rover Sport is as refined as it is powerful. It delivers smooth and composed handling thanks to adaptive dynamics, which reduces unwanted body movements. And when conditions change, dynamic air suspension keeps things balanced, optimizing agility. So your drive always feels effortless, even when the pavement disappears. Adaptive off road cruise control has your back. It adjusts in real time so you don't have to overanalyze every bump in the road, which means you can save that energy for debating your next credit card signup bonus. Visceral, dramatic, uncompromising. The Range Rover Sport leads by example, just like you do. Build yours today@Land RoverUSA.com Again, explore the Range Rover Sport@Land RoverUSA.com we are back.

[Elizabeth Ayola]

And we're answering your money questions to help you make smarter financial decisions. This episode's question comes from Mary, who wrote us an email. They wrote hi, I have a question about investing. About six years ago, I made my first attempt at the stock market without fully understanding what I was doing and definitely without the benefit of your podcast. At the time, I opened two accounts with Wells Fargo, a Wells Trade account and a wells trade IRA. Currently I have about $6,000 in the IRA, which is separate from my work 401k and around $3,000 in the wells Trade account. I honestly have no idea what's going on with my Wells Trade account. Since I initially invested it's in a mutual fund and the $1,000 I contributed back in 2018 has only grown to about $2,000. Is that a decent return? And if not, is there a way to move these funds into a better account or investment strategy? Thanks again Mary.

[Sean Pyles]

To help us answer Mary's question on this episode of the podcast, we are joined by investing nerd Sam Taub. Sam, welcome back to Smart Money.

[Sam Taub]

Good to be back.

[Elizabeth Ayola]

So let's first talk about what kind of growth is realistic to expect from an investment now. In general, what kinds of expectations can or should people have about their investments?

[Sam Taub]

Sam so when it comes to stock market investments like this, one good way to Think about a normal return is by looking at the long term average annual return of a stock index like the S&P 500 over the last century. The S&P 500 has returned about 10% per year before inflation on average. But that's just the long term average. In recent years, it's usually been higher than that, and in other years it's a lot lower than that.

[Sean Pyles]

So in Mary's case, after about seven years, their $1,000 grew to $2,000. And I'm assuming that's with no additional investments. And that growth amounts to a return of about 10%, which isn't too shabby. Can you put this in context for us, Sam?

[Sam Taub]

That's exactly the long term average. So it's not a bad return. But recently The S&P 500 has done a little better than that. Mary is up 100% in seven years, and the S&P is up 120% over that time. The fact that it's up less than the market is not necessarily a bad thing. Some mutual funds are designed to invest conservatively, which means that they won't go up as much as the market does during good times, but they also won't fall as much during a downturn.

[Elizabeth Ayola]

So Mary also said that they're invested in a mutual fund. We don't know what kind of mutual fund they're invested in, though. For folks who might be even wondering, like, what is a mutual fund? Can you give us a super quick explanation and then tell us maybe what kinds of returns people can expect from a mutual fund?

[Sam Taub]

A mutual fund is just a publicly traded basket of stocks or other investments like bonds. A lot of people find it more convenient to invest in mutual funds than to pick and choose a lot of individual stock and bond investments themselves. With a mutual fund, the fund manager is doing all that investment research work for you, and that gives you exposure to a lot of different investments in one purchase. And there are all different kinds of mutual funds. Some are index mutual funds, and they just track the returns of a stock market index like the S&P 500. Others are actively managed, meaning there's someone who's kind of more intently picking and choosing different stocks. Actively managed funds tend to charge higher fees, and some of them might beat the stock market index's returns from year to year. But generally speaking, most of them don't.

[Elizabeth Ayola]

I love what you said, Sam, about not liking individual stock picking, because I definitely fall into that bucket.

[Sam Taub]

It's a lot of work.

[Elizabeth Ayola]

It is, it is. And it can create like a Lot of anxiousness if you feel like you don't know what you're doing. All right. So our listener also seems interested in generating even greater returns from their investment. So how would they go about doing that? Mary said more specifically that they might need to move the funds to a new account, but that probably wouldn't be necessary, right?

[Sam Taub]

Right. If Mary wants higher returns and if she's comfortable with taking on more risk, it's probably just a matter of selling that mutual fund and putting the money into a more aggressive one. Now, of course, I'm not speaking as a financial advisor here, and listeners shouldn't take this conversation as financial advice. Having said that, given that this mutual fund seems to be more conservative than an S&P 500 index fund, switching to an index fund like that is probably a pretty cheap and easy way to accomplish the goal of getting more aggressive and seeking higher returns. Index funds tend to have really low expense ratios too.

[Sean Pyles]

Although we should say that even though you are potentially investing in a riskier fund, that doesn't mean that you're guaranteed better returns, right?

[Sam Taub]

That's right. It's higher risk and higher potential reward, keyword being potential.

[Elizabeth Ayola]

I had a quick question as well, Sam, if you can answer this. I know you mentioned selling a mutual fund and then putting the money into a more aggressive one. Would there be tax implications for that?

[Sam Taub]

If this is happening in her taxable brokerage account, in the one that is not an ira, then potentially yes. If it's in a retirement account, then capital gains tax is not something Mary's going to need to worry about.

[Sean Pyles]

So, Sam, underlying any conversation about risk and return and investments is the question of goals. I'm wondering, what is Mary investing for? When do they need this money? How do you see questions like this playing into Mary's question about what kinds of returns they should expect and what they're invested in?

[Sam Taub]

These are important questions because there might actually be a good reason why Mary put her money into this lower risk, lower return fund. If she needs the money in the next, say, five or 10 years, it might actually make sense to keep it in a more conservative fund, which again, won't grow as fast as a stock market index, but also won't lose as much money if there's a downturn. However, if Mary's investing for a longer term goal than that, then her investment would probably have plenty of time to recover from a bear market. And in that case, she's most likely better off getting more aggressive in her strategy.

[Elizabeth Ayola]

That makes sense. So, Sam, tell us, do you have any other thoughts about how investors should consider what makes up a good or quote unquote good return on their investments, and also how they can set realistic expectations for themselves.

[Sam Taub]

If listeners want to learn more about mutual fund returns in particular and what they should expect, our how to Invest in Mutual Funds page is a pretty comprehensive guide to these things.

[Sean Pyles]

All right, and we'll have a link to that in the show notes. Well, Sam, thank you again for coming on and talking with us.

[Sam Taub]

Of course, thanks for having me.

[Sean Pyles]

And that's all we have for this episode. Remember, listener, that we are here to answer your money questions. So turn to the Nerds and call or text us your questions at 901-730-6373. That's 901730, nerd. You can also email [e-mail] youm can follow the show on your favorite podcast app, including Spotify, Apple Podcasts, and iHeartRadio to automatically download new episodes.

[Elizabeth Ayola]

And here's our brief disclaimer. We are not financial or investment advisors. This nerdy information is provided for general educational and entertainment purposes and it may not apply to your specific circumstances.

[Sean Pyles]

And with that said, until next time, turn to the Nerds.

[E]

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