Small Investors Stuck in Catch-Up Mode

Investments in emerging markets and oil have been exceptional, leaving the U.S. stock markets in the dust for most of this decade.

Mutual funds that invest in emerging markets have posted average gains of 24% a year in the past three years, according to Morningstar, while the price of oil has risen fivefold since 1998 and by 65% this last year alone.

Sophisticated investors, as usual, got in at the beginning. Odds are that individual investors will climb onboard just as these and other high-return investments are heading downhill again, according to John Nofsinger, assistant professor of finance at Washington State University at Pullman and author of The Psychology of Investing.

"It's pretty easy to buy what has already gone up," says Nofsinger. It's much harder to invest in assets that have taken a beating.

He notes that famed investor Warren Buffett, chairman of Berkshire Hathaway (BRK Quote), was buying oil-related assets soon after the collapse of Enron soured the world's view of energy investments. "Now he's looking pretty good," Nofsinger says. "He's probably ready to sell."

The average investor isn't usually looking ahead, like Buffett, but looking into the rearview mirror instead.

"The return we've seen lately is what we expect in the future," says Nofsinger. "We naturally look to what has done well recently. It causes us to buy high."

Another reason the typical investor doesn't fare well by jumping on the bandwagon is what is known among those who study behavioral finance as "representativeness bias," he says.

For example, because new cars have a clean and fresh smell, we might be inclined to think that all cars with a clean and fresh smell are good ones. Not true, of course. Likewise, it's easy to assume that a good company is a good investment, notes Nofsinger. But it could be a poor one if the company is overvalued.