Top 6 ways Investors sabotage their Investments
The old adage, “The best offense is a good defense”, couldn’t be more applicable than in the world of finance. Knowing how to make money in the stock market is great, but knowing how to lose money -and avoid it- is even better. It seems like the more people we ask about their experience in the stock market, the more we find that they have lost a ton of money, many of them still resisting getting back in the market. It would almost appear that losing money is a lot easier than making money, almost like fighting gravity, and we agree. Below are what we believe are the top 6 reasons investors lose money in the stock market, in no particular order, as we believe they are all equally important, and in fact, most are interconnected to each other.
- Buying High, and Selling Low
This may sound obvious but many investors make this mistake so often that we had to write it down. We were originally thinking about showing graphs of price and volume of several (now) popular stocks and show that when prices are high we have high volume (i.e. a lot of shares are being bought/sold) but when prices are low, everybody and their grandma is selling and buyers don’t come back until the price of the stock is high again. However, when looking at the volume, it’s impossible to tell whether the people buying/selling were individual investors (i.e. Retail investor) or professional investors. So, we got the next best thing which is the how many retail investors got in and out of mutual funds, which is data provided by the Investment Company Institute (ICI), along with our comments.
Some may say that investors in Equity are not as knowledgeable as Bond investors. Well, Bond investors didn’t do as good either. When the FED Funds rate is lowered the Price of current Bonds in the market go up; when the rate is increased, the Price of current Bonds goes down. As shown in the graph below, investors were buying lots of Bonds at the wrong time.
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Not Taking enough Risk
Risk is a subjective thing because not all the different types of risk can be appropriately quantified. Nobody knows with 100% certainty what will happen in the future because there’s always some type of risk. Each company could be subjected to regulatory risk, that is, the risk that laws may change and affect the profits of the company (and the stock price); there could Business Risk, where the management of the company makes a management mistake that could tank the stock price. There’s also Financial Risk, which is more quantifiable.
Market Risk is also pretty common, it essentially means the market as a whole will lose value and it doesn’t matter what type of stock you buy, you’ll likely to lose money even if you “diversify” by buying several stocks. This is typical in Recessions.
However, a longer time horizon usually reduces the chances of losing money. The Longer the time horizon, the less risk of losing money. In other words, if someone can invest money and is not expecting to use that money for many years (10, 20, etc. years) then the risk of losing money will be reduced but, more importantly, the money invested will gain a lot more than investing in non-risky equities.
In the world of Investing, usually High Risk = High Reward whereas Low Risk = Low Reward. The younger the investor, the higher risk that investor should assume when investing for retirement or other long term goals. Once again, stats by ICI show most people are low risk takers, especially those under age 50 . This severely affects long term gains. Given the statistical mortality rates, even those age 50 have over a 20 yrs investment horizon, allowing them enough time to assume more risk and potentially higher return.
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Taking Risk at the Worst Time
While, overall, investors are not risk takers as shown in the bar chart above, many investors take on a little more risk at the wrong times. The problem is, investors are more Risk takers when the market is doing extremely well, that is, when it is “expensive” but investors become quickly Risk Averse once the stock market crashes, that is, when it is “cheap”. Investors seem to keep on doing the opposite of what’s good for them! Again, ICI has a chart showing us the irrationality of investors.
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Taking the Wrong kind of Risk: Trying to Beat the Market
Another problem with some investors is that some of those that do take Risk end up taking unnecessary risk. When reading the news, blogs, forums, or simply talking to people one can see that many investors are over preoccupied with the concept of beating the market. Many of these investors end up chasing “hot” stocks that have all the hype but no real numbers to back up the stratospheric valuations; If you’re a technical trader, that’s OK because you’re quicker at getting in and out, but, if you’re the average investor you’re playing with fire.
The best example we have is from back in the late 1990s when many investors were running to buy any stock that had a “.com” behind its name and yet many of those companies no longer exist today and many of those that still do have yet to recover from the losses in stock prices. As an example, below is the Yahoo stock performance as plotted by Google Finance; as you can see, Yahoo is one of the surviving companies of the dot-com bubble but after almost 15 years the stock price is still very far from it’s all time high.
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Keeping an Eye on the Wrong Things
Many investors look at their brokerage account daily or weekly. Some even look at their account every time there are “bad” news. Greece seemed to be a topic that keeps on appearing in the news for several years, then Brexit, then Trump and these news seemsto affect the market quite often. Some investors might even be selling on bad news. If one thinks about the role of Greece in the World economy or even Brexit, one will realize it practically doesn’t matter what happens. Microsoft will keep on selling software, Caterpillar will keep on selling bulldozers, Johnson & Johnson will keep on selling soap. However, in the short term, investors tend to irrationally think the worst and thus prices tend to drop in the short term, even if rationally it may make no sense.
We are of the opinion that the less frequently someone looks at their account, the less likely they’re going to make a buy/sell decision that is based on “hype” or emotion instead of rational thinking. If someone is a professional investor or trader then sure, they have to look at it every day, but, the retail investor is better off exercising patience.
One of the things we like to point out to investors is to consider the value of their own homes. While we know there was a very high rate of home foreclosures from the 2007-2009 recession, most homeowners were able to keep on paying their mortgages and weren’t too concerned about the fluctuation in price in their homes. We believe the reason is that a person’s own home price is not traded daily, there’s no Exchange for someone’s own house price, and yet prices do vary. Below is a chart showing the Case Shiller Home Price Index (which we took from multp.com). If you go to Trulia.com, you can also find how your house value has theoretically changed in price every month.
As you can see, in average, a huge drop in home prices occurred in the cities the Index follows and yet most homeowners didn’t panic, they didn’t sell their houses in droves. If most people would have sold their houses many more people would have lost money and prices would have gone even lower.
What else happens when you look at the market on a frequent basis? You lose patience. The market rewards those who are patient and are willing to sit and do nothing while short term fluctuations happen.
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Confusing the Financial Advisor for an Investment Manager
Every time there’s a recession and people lose money it would appear like the first thing they complain is their financial advisor for not selling the stocks, mutual funds, etc and investing in something else. This to us sounds unfair because the financial advisor performs a different service to investors (offering products such as mutual funds, annuities, specific stocks, etc) but investors confuse this service with money management or portfolio management. The offering of products and money management are two completely different services usually performed by different persons. The Financial Advisor is in fact, not an Advisor at all (heck, not even their license has the word “advisor” in it).
In general, if an Investor is buying Mutual Funds, annuities, etc from a Financial Advisor then the investor himself is the manager of his portfolio. So if the investor would like to sell some of his positions usually the investor would call the financial advisor to tell him/her to liquidate the position (unless the Financial Advisor would call the Investor first to offer him something else to buy). Usually the Financial Advisor would get paid via a commission and usually that commission is paid by the client through the company issuing the product. For example, a mutual fund company would pay a certain percentage as commission to the financial advisor; Say the investor buys $10,000 worth of mutual funds and pays a 4% commission. Then the Fund would take $9,600 to invest in the fund and $400 to pay the Financial advisor.
On the other hand, if the investor wants a professional to manage his portfolio, then he would employ an Investment or Money manager (aka Investment Advisor). In that case, the manager would determine what to buy/sell, when to buy/sell, how much to buy/sell, and price to buy/sell, on behalf of the client. So there wouldn’t be the need for the investor to call the Investment Manager to tell him what to sell or buy because the manager would be in charge of making those decisions. Obviously, the client can still call and ask for positions to be liquidated but the Investment Manager would generally advise against it unless the client is making a withdrawal for personal reasons. The Investment Manager doesn’t get commissions for selling any products because his job is Not selling products but to actually manage the portfolio, so his compensation is a fee based on annual percentage of assets under management paid also by the investor.
So, there are benefits to Investment managers (aka Investment Advisors) but not so much for Financial Advisors if the investor wants someone to manage that portfolio, it just depends on what the investor wants to do. More on the topic of financial advisors can be found in our article Do Financial Advisors beat the Market?