Many people wish to take the reigns of their investing and account management. And that is totally OK for the right person! However, a common denominator is we are all human, and as humans, we have our own bais, beliefs and emotions that can often de-rail good intentions into mistakes. In fact, Dalbar Inc., a company that studies investor behavior and analyzes investor returns has consistently shown that the average investor earns below-average returns. (1) For the twenty years ended 12/31/15 the S&P500 averaged 9.85% and the average investor earned a market return of 5.19%. So what could have caused that? Let’s review 5 mistakes a common investor makes:
- Emotions: To quote a famous economist, Gene Fama Jr., “Your money is like a bar of soap, the more you touch it, the smaller it gets.” The truth is – we all face two very primal issues in investing, greed and fear. And both can ruin what could be a good return. Many investors tend to chase performance, buying too high or too late, and also holding on too long. The last two weeks have shown this point and case in the GameStop (GME) rally. Many retail investors saw the swift and fast run-up of the stock price and thought it will keep going, well – trees don’t grow to the moon. And as I write this (February 4th 2021) GameStop has fallen 70% in the last week. Investors should have a time to “harvest a gain” and set reasonable expectations of when to get out, if they are trading. Secondly, you never want to catch a falling knife. Many investors see an investment fall, even small drop likes -5 or -10% and very natural fear kicks in, because it’s their hard-earned money. Something we have learned is that normal market fluctuations are normal, and to be expected, and when you sell – you lock in losses permanently, and don’t allow prices to recover.
- Know What you Own: “My buddy was telling me about a new medical company that develops some kind of enzyme from swamp grass that can cure cancer, or maybe develop metals for homes on the moon – this has to be a great company to invest in.” News headlines, conversations and “next best stocks to own” ads often have people chasing a fantasy, without knowing about it. There is an old adage – to invest in what you know. Warren Buffett was very popular in this and avoided many Technology companies due to the fact, he couldn’t understand them, yet he invested in the industries and companies he understood. Secondly, if you’re investing in mutual funds or ETF’s, which are baskets of companies – do you know what companies they own? And how much of each company? These are important components to diversification, but also to know why a fund or ETF is performing better or worse than any other.
- Recency Bias: When we see a stock, index or sector doing well – we as humans tend to think that will go on forever. But in reality economic cycles, commodity prices, monetary policy can all indirectly or directly affect individual performance, for better or worse. The affect of this bias is usually buying high, versus buying low. Remember to treat investments like a big sale at the grocery store or a clothing store – take advantage of a discount, when there is one!
- Market Timing: To continue with mistake #3 – many investors think they can out-smart the market; and if this were so easy to do – everyone would do it, and everyone would be wealthy! The truth is no one can get out, and back in the market, at the perfect time. A study showed that $10,000 invested in the S&P500 in 1950 would have averaged 7.5% as of 3/31/2020, for a total amount of $1,567,209. Whereas if you only missed the 10 best days (out of 17,500 trading days) your return drops to 6.2% for a total return of only $693,849 – less than half, if you just stayed put! (2) It’s very normal to want to avoid the normal fluctuations (Dot.com bubble, financial crisis of 2008, Black Monday, etc.) – but by avoiding the normal, and short-lived downturns, you miss the healing, and return.
- Value Traps: This is for the stock pickers out there. It’s true, buy low and sell high, while there are times to buy good companies at a discount, just because they are down in price doesn’t make them a good long-term hold. Economies change, innovation changes and consumer needs change. JCPenney was once a very profitable company, and Amazon started as an online bookstore. Investing is usually most successfully done by looking forward and not backwards. If a company is on sale, it may be more due to specific issues such as earnings, a dying technology or management changes and sometimes these make a ‘cheap’ investment not turn into a pile of gold.
Investing on your own can be rewarding, fun and give you ownership of your success. If you don’t feel comfortable and rather use a professional – that is OK too. And never forget, many advisors like myself can work alongside clients to help advise, review and plan for your investments. Investing is a small component of financial well-being and hiring an advisor as an advocate and fiduciary can pay dividends in the long run!
Investing involves risks and potential loss of principal. Investing should be based on your risk profile, goals and financial circumstances. Not all individuals should be trading stock or investing and need to review their individual circumstances. The research and historical data do not include trading costs, fees or taxes. Andrew Rose, Capitol Financial Solutions and Royal Alliance Associates, Inc. are unaffiliated with the articles and research.