Successful people learn from the mistakes of others, yet the investment world is littered with people making the same faults over and over again. What are these mistakes and how can we avoid them? Let’s take a look at some of the more universal strategies that investors use that cause financial burns.
One of the most common mistakes that people make when investing is their tendency to make their choices based on the recent performance or on the mutual fund’s track record. This is rooted in our desire to avoid pain and seek pleasure. If something is painful, it is only natural to try to avoid it and move toward something we view as more pleasurable. For instance, in the year 2000 (when the tech crash started), government bonds returned a soothing 21.49%. During the same year, small company stocks produced a loss of 13.56%. Faced with those numbers, our instincts would tell us to move money away from the small stocks and put them into government bonds. After all, doesn’t it just make sense to get out of a burning building? The only problem with that reasoning is that it discounts the fact that investment markets are cyclical and those cycles are unpredictable.
As a case in point, over the next calendar year (2001), small company stocks actually returned a positive 34.12% compared with a paltry 3.7% for government bonds. Unfortunately, very few investors benefited from the small company returns, because their instincts drove their decisions. An 11 year study by Dalbar Research actually revealed that this phenomenon is not just limited to the general public. Commissioned advisors also had fallen prey to the same forces. Even though the market had averaged over 13% during the study, the average return for advised and non-advised investors was less than 5%. In essence, the investing public would like to get stock market returns with Treasury bill risk. Instead, they are getting Treasury bill returns with stock market risk.
Another common mistake is confusing diversification with owning a lot of stuff. It is important that we understand what is really meant by the term diversification. This term is almost so overused by investors and advisors alike that it has become meaningless. Most people use the term to mean, simply, “owning many different funds or stocks”. Unfortunately, this definition isn’t adequate by any measure. I may own 15 different mutual funds, but it does me little good if all of the funds own the same set of stocks. Even worse than that is the problem of owning a limited number of stocks. New academic studies show that individual stocks are much more volatile today than they were in years past. Those same studies also pointed out that individuals investing in individual stocks were not rewarded with higher returns for taking that risk. The returns were actually lower. Why? Volatility matters. Additional volatility added with the individual stocks can actually be of more detriment than a lower annualized return. The problem is few investors know how to measure risk in their investment portfolios. Obtaining a greater understanding of the true meaning of diversification means learning what asset classes are held inside your funds and focusing on how they tend to move with and against each other. In other words, large US stocks, small US stocks, international companies, government bonds, etc., don’t tend to go up and down all at the same time. Knowledge of their historical correlations can be helpful in designing an appropriate portfolio.
If all of this sounds too difficult, don’t worry, it can be learned. In fact, it is very important that an investor have a basic knowledge of these concepts. This is all part of the coaching process. As a client of mine put it, “I don’t have to know everything about playing shortstop to enjoy the game of baseball.” While we’re not talking sports, I should also note that it is very hard to take advantage of an informed investor.