Rule 2: Proper Investor Behavior
The second rule, proper investor behavior, is the most important. Without it, even the most exquisite asset allocation ever devised by man (even with the direct assistance of Warren Buffett himself) is almost certainly doomed to terrible failure.
Here is an example of how investor behavior can thwart investment success.
One of the largest mutual funds in the United States is the Investment Company of America (AIVSX). Over its impressive 73-year history, the fund has delivered an average annual return of 12.8%. It sounds like anyone in this fund would have always been very satisfied, but in reality, it has had negative years, just like most other funds–or other investments, for that matter. Had you invested $10,000 in the fund at the beginning of 1973, a bear-market year, the value of your investment would have fallen 16.8% by year-end. Even worse, by the end of 1974, it would have been down another 17.9%. Don’t even mention the front-end sales load of as much as 5.75%! By the end of 1974, many investors would have been so dismayed to see their investment decline by more than one-third that they might have bailed out.
Many investors who sell out of fear at a loss are too wounded to reinvest, and sadly, they often miss out when the market rebounds. Had they just stayed invested and understood that bear markets are merely a part of the normal order of stock markets, they would have recovered all of their “losses” (which they really did not lose if they did not sell) and ultimately made a very nice profit. The fund broke even by the end of 1976 and would have grown the initial $10,000 investment into $24,000 by the end of 1982.