The last column I wrote had to do with why, during record-setting markets, people are not feeling that confident about their 401(k)s. And as of this writing, the market has hit yet another high. So why isn’t everyone dancing in the streets?

I believe it’s because people are beginning to realize it doesn’t really mean anything. The reason is, even though the market does very well over time, it’s difficult as an individual investor to receive and retain those gains.

Dalbar Inc. is a company located in the Boston area that has studied investor behavior during the last 25 years. What they have found is startling. While the average market returns during the last 30 years average a bit more than 10%, the average investor only averages a bit under 4%. That’s because we really suck at investing. Most people, when managing their own money, are driven by fear – fear of losing and fear of losing out. That causes us to react negatively both when the market is declining, and when it’s increasing. When the market is crashing, we hold on until we can’t stand it any longer and then sell. Once it starts back up, we wait until we can’t stand it any longer on the way up and then buy once the market is high.

Think about the past couple of decades. In the year 2000, the Dow was at a historic high of 11,522, and it was the end of the most incredible 20 years in market history.

Then the tech bubble burst. And right on its heels, 9/11 happened. By October 2002 the Dow had declined to 7,528, for a 35% drawdown in slightly less than two years. Of course, it then began to climb back, and by October 2007, it had not only recovered but reached a new high of 14,000. Once again, life was grand, and everything was fine. Until it wasn’t.

Of course, that was the Great Recession, and the 53% crash that preceded it. Now the Dow was at 6,626, and everyone was panicking, as trillions of dollars seemingly disappeared overnight. Now, we were down even lower than at the end of 2002, with no idea what was next.

How did you fare during that time? Many of the people I talk to did exactly what you would expect, selling low and then buying back in once the markets recovered, driving down returns and exacerbating losses.

But market risk isn’t the only thing holding us back. The other big thing is fees.

According to the Wall Street Journal, “U.S. stock funds pay an average of 1.31% to the portfolio manager and for other operating expenses.” However, it goes on to quote Morningstar, “There are other costs not reported in the expense ratio related to the buying and selling of securities in the portfolio and those expenses can make a fund two or three times as costly as advertised.” In other words, you can expect to pay anywhere from 2% to 3% in fees, and that doesn’t even count the administrative costs associated with a retirement plan such as a 401(k) or 403(b).

According to Jack Bogle, the late founder of Vanguard, a 2% fee over an investing lifetime can deplete an account by up to 66%. I had a difficult time believing that, so I decided to test it. I ran an illustration, showing $100,000 deposited into an S&P 500-indexed account in 1960, and found by the end of 2016, it had grown to about $3.2 million! Then I applied a 2% fee, and found it only grew to $1.093 million, which is about 1/3 as much. So, Bogle’s observation proved to be true.

How can you mitigate this? First, you should be thinking in terms of very low-cost ETFs and index funds. But not just any ETFs and funds, because, as we have seen, fees are only part of the problem. For example, one of the most common indexes people use is the S&P 500. That’s because, through time, it performs well, and the funds indexed to it are plentiful and inexpensive. Plus, most people are aware of it, so they feel comfortable.

However, while the index can average 7% to 8% through time, it’s also very volatile. The standard deviation on the S&P 500 is around 15%. Assuming normal distribution, 68% of the time the returns can swing by up to 15% (one standard deviation), and 95% of the time will stay within two standard deviations, or 30%. That’s quite volatile, and for most people would be very difficult to stick with during down markets.

The way we would address this with a client would be to first determine their Risk Number. The S&P 500 has a very high Risk Number of 78. Most people who come into our office have a number in the mid-40s to low 50s, so 78 would be intolerable for them. But the most common index is the S&P 500, because it’s common and inexpensive. In other words, most people using indexed funds end up using the ones that are cheap. Is that what you want for your retirement? The cheapest fund?

We find that most people, once they understand, choose a different option. But in order for it to work, it has to begin with the investor’s Risk Number, not the investments. This gets back to our core management philosophy, which is begin with the client, never the investment. Far too often, we find people directed to the more common investments, like the S&P 500, which becomes very difficult for the average investor to stomach, and that creates real problems in reaching your goals. It doesn’t matter how inexpensive a fund is if you can’t stand to stay with it.

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. Steve Kelley may be reached at 603-881-8811 or at www.FreeToRetireRadio.com.

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