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November 06, 2008

The Five Biggest Mistakes Investors Make

I was doing a program the other evening for a group of employees from one of the larger DFW area employers. Before it started, I was talking with one of the attendees about how your emotions are what make investing so difficult. We had a really nice conversation but, try as I might, I don't know think he was totally convinced of the impact our emotions have on us as investors.

 

Given that “emotions are your worst enemy” is one of the six fundamental tenets of my investment philosophy, I was somewhat frustrated by my inability to help him see something which to me is so plainly obvious. Then a funny thing happened. As the night wore on, the attendees themselves demonstrated each of the mistakes I was trying to get the gentleman to understand. Sometimes, a picture really is worth a thousand words.

 

Expert bias

 

I spoke with one woman who told me she appreciated my talk very much but had no interest in managing her own investments. I asked what she was investing in currently. She wasn't really sure.

 

"How do you know whether the investment is the best one for achieving your objectives?"

 

"I don't,” she replied, “I am really not happy with my investments. I’ve been investing with him for fifteen years and I don't have anything to show for it."

 

When I asked why she didn't manage them herself, she seemed shocked at the notion.

 

"That would be like doing surgery on myself," she said.

 

This is what is called "expert bias." It is very strong and it can be very dangerous. In the medical field, researchers attribute many of the errors in patient medication, for example, to a blind deference to authority. Take the rather comical story of a physician who ordered ear drops be given in the right ear of a patient with a painful ear ache. Presumably to save time, the doctor wrote, "Place in R ear." Upon reading the prescription, the on-duty nurse promptly put the required number of drops in the patient’s rear!

 

Clearly, treating an earache through the backside makes no sense at all. But apparently neither the nurse nor the patient questioned it. The moral of this story is, when someone we perceive as an expert gives instructions, we take leave of our own powers of critical thinking, even when it directly contradicts what we know to be true. As an investor, this is a very costly mistake.

 

What to do about it: Do not assume that just because someone is a financial advisor, regardless of the letters behind their name, they know what they are talking about or are putting your best interests ahead of their own. The only way to avoid what I call the tax on the uninformed is to know enough to, at a minimum, be able to participate in all decision-making related to your financial future. An even better solution is to manage your own money.

 

Stock picking and market timing

 

Another gentleman was a trader type. He bought and sold constantly. I asked him how he was doing. "Not very well right now," he said. "But that's just because I don't have enough time to pay attention to it." If only I had a dollar for every time I have heard those words.

 

Here’s the deal. Stock picking and market timing are incredibly seductive. 20/20 hindsight gives you the false impression that both should be fairly easy. So if you fail at it, or your advisor fails at it, the natural response is to make up some excuse for why they failed.

 

Here is the real skinny on each. Let's start with stock picking. Stock picking is the misguided idea that through either fundamental or technical analysis we can pick the "best" stocks. So let's think rationally about this. In theory, who should be the best judge of whether or not this is really possible?

 

Mutual fund mangers, right?

 

Isn't that what they get paid millions of dollars a year to do? To pick the stocks which will go up more than the market? Or to pick the stocks that will not go down as much in a bear market?

 

But an objective viewing of the evidence shows us that stock picking can't be done. Two-thirds of actively managed mutual funds under-perform the market in any given year. In other words, if the market goes up, they go up less. If the market goes down, they go down more. And the ones that do outperform are different from year to year which tells us the ones who outperform do so not from skill but rather from luck.

 

What about market timing? Market timing is the practice of getting in or out of an asset before an anticipated move up or down. So in its most basic form, a market timer would go to cash when the market was trending down and be fully invested in the stock market while it is trending up. Again, the evidence says it can't be done. Many studies have been done of the market timers, and none are able to consistently beat the market over any length of time.

 

Why is it that something which seems so easy is so hard? Here is what no one tells you. Most of the market gains and losses occur in a very small number of days. For instance, if you missed just the five best days during the ten year period ending December 31, 2006, your return would have dropped from 8.5% to 5.5%. If you miss the twenty best days, your return would be negative! The clincher is those days typically don't occur in the middle of a cycle but at the beginning or end when the market timer is sitting on the sidelines waiting for the new trend to be confirmed.

 

What to do about it: A fundamental truth about investing is that prices are random. Until you understand that, your brain is always going to be able to trick you into believing that you can predict the future direction of price. There are two things you have to do to avoid this mistake: 1) stay invested all the time - even when it feels bad and 2) tie the achievement of your investment objective to the amount invested, not the market value, which will fluctuate a lot during market cycles.

 

Staying in a bad investment until it gets back to break even

 

The guy I was talking to originally was really funny. At the end of the evening, after I had pointed out all these emotional mistakes, he laughed and said, "You are right. I guess emotions really do play a large part in our success or failure as investors." I was relieved. Finally I was making some headway. At which point he said, "I really like the sound of your program. But I wouldn't want to sell what I am in while it is down."

 

Perfect. Another teaching opportunity!

 

What I wanted him to understand was that this was yet another example of the mind playing tricks on us. Psychologists tell us the pain of loss is much stronger than the possibility of pleasure. As a result, we will often do harm by trying to avoid the pain of loss at the expense of a greater reward.

 

"Let’s imagine your portfolio was $500,000 but now it is down to $350,000. Let's assume that your current portfolio will average 5% return over the next thirty years, but some new investment you are considering would average 6%." I was just making up numbers for illustration purposes. "You can either sell the existing portfolio and put it all in the new investment or you can hold the old investment until it got back to $500,000, then sell it and put it in the new investment. Which will give you more money at the end of thirty years?"

  

He smiled. "Well, when you put it that way."

 

With perfect knowledge of the future, the obvious answer is to sell and purchase the better-performing investment. He will have more, over any timeframe, by putting it in the new investment sooner.  Of course, these are just made up numbers and we never really know how any two investments will do in the future.  But the point is, like so many of the decisions we make about money, this one is emotional – not rational.

 

What to do about it:  You chose your investments based on how likely they are to meet your stated investment objectives and tolerance for risk over a given time horizon. Whether to sell or hold an investment has nothing to do with the price you paid for it. That is done - in the past. The only thing that matters now is what is likely to happen in the future.

 

There are two more tricks our brain plays on us as investors. One is our propensity to buy high and sell low over and over again. The other is sticking with something that worked once even though the probabilities of it working long term are low. A sports analogy would be the six foot seven inch center in basketball who takes a long range, three point shot and makes it. He then spends the rest of the game shooting outside jump shots when his odds of repeating the feat are dismally small. It costs his team the game. In the interest of space, I think I will save these last two for the next newsletter.

 

In the meantime, if you would like to learn more, I encourage those of you in the Dallas Fort Worth area to attend the upcoming briefing on Thursday evening, November 13th. It’s called, What to Do When You Can't Trust Wall Street - or Washington.   I will discuss the recent trends making the job of the Family CFO so difficult and offer up my solutions. You can register on our website at snideradvisors.com.

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Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax or other advice and are provided for informational purposes only. This article is not a complete discussion of the benefits and risks of the Snider Investment Method®. For a complete discussion, read the Snider Investment Method® Owner's Manual, available by calling 888-6SNIDER. Please read and consider carefully before investing. All investments, including the Snider Investment Method® are subject to risk, including possible loss of principal. Income is objective and not a guarantee. Dollar cost averaging does not guarantee you will not experience capital losses.

Posted by Kim Snider on November 06, 2008 | Permalink