Investors’ 10 most common mistakes

Investors’ 10 most common mistakes
Barry Ritholtz
Washington Post, July 11

Whenever there is turmoil in the markets, my phone lights up with calls from journalists, investors and potential clients. They are typically in a panic about the crisis of the moment and are calling for my take on the situation.

In my decades as an investor and analyst on Wall Street, I have learned that panics come and go. They turn out not to be the main cause of investors’ financial setbacks. Rather, what hurts most investors most is a failure to understand the basics of investing. Not grasping the simple mathematical drivers of returns invariably leads to very costly errors.

The best time to make an investment plan is before a crisis, not during it. When the sky turns cloudy, you should follow your plan, including all “exit strategies.”

Consider these 10 points in the context of your own discretionary investments, 401(k)s and IRAs. Identify any errors you are making, and fix them now — before the next storm hits.

1 High fees are a drag on returns: Fees are an enormous drag on long-term performance, according to every study that has ever looked at this issue. Typical mutual fund or adviser fees of 2 to 3 percent may not sound like a lot, but compound that over 30 or 40 years, and it adds up to an enormous sum of money.

The typical hedge fund fee structure of 2 percent plus 20 percent of the profit is an even bigger drag on returns. Other than a handful of superstar managers (whom you probably don’t have access to), the vast majority of hedge fund managers simply cannot justify their costs. The same is true for most of the retail stockbrokers and for many of the investment advisers on Wall Street.

Across all of my managed-asset clients, my goal is to keep fees down to an average of about 1 percent. You should expect to pay a little more for small portfolios and somewhat less for much bigger ones.

2 Reaching for yield: There are few mistakes more costly than “chasing yield.” Don’t take my word for it — just ask the folks who loaded up on subprime-mortgage-backed securities for the extra yield how that worked out for them.

There are three common ways to chase yield: 1) by buying longer-dated bonds; 2) by buying junkier, riskier paper; or 3) by using leverage, which amplifies your gains but also amplifies your losses.

With the 10-year Treasury yielding just 1.6 percent, I see lots of folks trying to capture more income using some combination of the above. Anyone who engages in this sort of ill-advised, risky behavior should understand the risks and what they might mean if and when things go awry.

3 You (and your behavior) are your own worst enemy: Your emotional reactions to events are yet another detriment to your results. Do you get excited about hot new companies? Do you love chatting about stocks at cocktail parties? On the other hand, are there times when you cannot bear to even open your monthly statements? Do your investments keep you up at night?

If so, you, like most people, are an emotional investor. This typically manifests itself in two ways: by the buying of stocks at the highest valuations as excitement builds near the top of the cycle, and by panicked selling near the lows.

You can take steps to protect yourself from, well, yourself. Set up a mad-money account with less than 5 percent of your capital. This will allow you to indulge your inner Jim Cramer. If the investments work out, that’s great. If they turn out to be a debacle, it’s a terrific lesson that should remind you that trading in and out of stocks is not your forte. Be thankful you didn’t lose most of your retirement assets.

Your emotions are often the enemy of your financial well-being. Keep them in check!

4 Mutual funds vs exchange-traded funds: The average mutual fund charges far more than the average ETF. Whenever possible, I recommend substituting a low-cost ETF over a more expensive mutual fund.

The fund industry seems to have figured this out. Some companies have put out ultra-low-cost mutual funds that typically mimic broad indexes. Others have ETF-ified their existing mutual funds, converting some into ETFs. It would not surprise me if nearly half of the existing mutual fund offerings morph into ETFs over the next decade.

Even within the ETF universe, there is a wide range of internal fees. These expenses come off the top of your investment performance, so it pays to watch them closely. Reducing your costs is a surefire way to improve long-term results.

5 Asset allocation matters more than stock picking: The decisions you make about the mix of your assets have a far greater impact on your success than your stock picking or market timing. This too has been proved repeatedly in academic studies and the real world.

If your allocation mix contained too few equities over the past few years, you probably missed out on the 100 percent rally in stocks since March 2009. And if you a lack of bonds in 2008, you had nothing protecting you as markets fell.

The world’s greatest stock pickers all got crushed during the 2008 crisis — and a monkey could have thrown a dart at a list of stocks in 2009 and made a ton of money.

Stock picking is for fun. Asset allocation is for making money over the long haul.

6 Passive vs. active management: Speaking of which: Active fund management — when managers try to outperform their benchmarks through superior stock picking and/or market timing — is exceedingly difficult. It has been shown repeatedly that 80 percent of active managers underperform their benchmarks each year.

What’s worse, most active managers typically run higher-fee funds. That combination — high fees plus weak performance — is not a winning long-term strategy. This is why passive index investing is a superior approach for most investors.

Your portfolio might be better served by replacing some of the actively managed funds with passive indices.

7 Not understanding the long cycle: Societies, economies and markets all move in long — or secular — eras. Sometimes these periods are positive (1946 to 1966 and 1982 to 2000, for example) and are called secular bull markets. Sometimes they are negative (1966 to 1982; 2000 to ?) and are called secular bear markets.

Let’s look at the 1982-to-2000 era. The rise of technology — including software, semiconductors, mobile, networking, storage and biotech — drove the broader economy. This led to record-low unemployment, strong wage gains and high corporate profits. As you would imagine, stocks did exceedingly well in this environment. Investors whose asset allocations were equity-heavy did much better than those whose held lots of bonds and cash during that period. Conversely, the cycle that began in 2000 has rewarded bond- and cash-heavy portfolios and has punished more equity-heavy ones.

Not understanding this cyclical backdrop is a common error. You should be more equity-oriented during secular bull cycles and more tactical (that is, invested in bonds and cash) during secular bear cycles. Investors should understand the secular backdrop and adjust their allocations accordingly.

8 Cognitive errors: Beyond those emotional foibles, many investors suffer from cognitive foibles. These are the errors inherent in your wetware — namely, the way your brain has evolved over the millennia. Suffice it to say that capital-risk decision making was not a big issue on the Serengeti plains. Not getting eaten by lions was.

Humans have a number of unfortunate tendencies that get in our way when it comes to investing: We see patterns where none exist. We have difficulty conceptualizing long arcs of time. We selectively perceive what agrees with our preexisting expectations and ignore things that disagree with our existing beliefs. We tend to forget our losers and overemphasize our winners. In short, we simply are not wired for investing.

We cannot avoid these built-in shortfalls. But at least if we are aware of them, we might hope to avoid their most pernicious effects.

9 Confusing past performance with future potential: We’ve all seen the boilerplate disclaimer that comes with anything investment-related: “Past performance is no guarantee of future results.” Despite its ubiquity, this warning is routinely ignored by investors.

Consider this. When Morningstar gives a mutual fund a five-star rating, the fund attracts lots of new investors and fresh dollars. The primary factor in the rating is (can you believe it?) past performance. This despite a Morningstar study that found that five-star funds mostly underperform — my assumption is that it’s a case of a simple reversion to the mean. As it turns out, a fund’s expense ratio is a much better predictor of performance.

When making any investment, be sure you are not merely chasing a hot quarter or two.

10 When paying fees, get what you pay for: It always surprises me how much money some people are willing to throw at others to manage their financial affairs when it is not necessary.

For many people, hiring a pro makes good sense. Let’s say you have a complex financial situation. You may have a complicated tax issue, or perhaps you have a generational wealth transfer coming up. Then sure, it makes lots of sense to employ a professional. Lots of clients are too busy running their own businesses and do not have the time to manage their investments. But many others might be better off simply dollar-cost-averaging into a group of broad indices.

Consider what sort of financial planning help you need, and find someone competent to assist you. If your needs are straightforward and simple, you might be able to save the fees and do it yourself.

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Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture. You can follow him on Twitter: @Ritholtz. For previous Ritholtz columns, go to here.