Everybody makes mistakes. The difference between success and failure is how you deal with those mistakes. Nowhere is this more prevalent than in investing. Today I will highlight 3 of the most common mistakes I see investors make, and hopefully this will help you avoid the errors so many others have made.
1. Waiting to Get Even
It is common for investors to buy a stock that declines in value and then, regardless of underlying fundamentals, hold the stock until it at least gets back to the price they bought it for. Many people hate the idea of selling a stock at a loss, so they may hold on to a particular stock too long while other opportunities pass them by. Behavioral finance describes this as a cognitive error. By failing to sell certain stocks, investors can lose in two ways. First, they can hold onto the stock as it continues to decline in value and possibly ends up worthless. Second, there is an opportunity cost, where the stock could have been sold and proceeds reinvested in a stock with more upside that make up the value lost in a more timely matter.
No time was more evident of this than the dotcom bubble that burst in 2000 and led to a steep bear market. Many investors froze, not knowing what to do and did not sell until the value of their portfolio had been cut in half. People were lulled in by a false sense of security during the 90s, thinking stocks were going to continue to go up. Remember, we were in the “New Economy,” where economic cycles were a thing of the past. In hindsight, we can see what a ridiculous notion that truly was.
Getting your portfolio back to where it once was can be difficult, especially if you are hanging onto losers because you cannot stand to sell at a loss. If your portfolio falls 30%, you need to go up 43% to get back to even. A decline of 50% requires an increase of 100% to get back to even. Too many people believe if a stock drops 20%, they just need a rise of 20%, but basic math proves otherwise. This is not true in every case. Some stocks can decline in price and make a quick rebound, but stock fundamentals cannot be ignored. The same mistake can be made with mutual funds, ETFs and bonds.
2. Market Timing
Being able to time the market consistently and accurately is the holy grail of investing. No one, in the history of the stock market, has been able to do this. Timing the market means being able to forecast dips, corrections and bear markets and move assets out of stocks as these events occur. But that is only half the battle, as you have to forecast when to get back in as well. That is two decisions that you would need to get exactly right. The reality is most investors who attempt this end up getting whipsawed, meaning they sell too late and get back in the market too late. In other words, they capture all the downside and miss the upside. Small declines, and full-blown 10% corrections, are impossible to time because they are just normal market movements and happen based on emotions and fear, two things that cannot be forecasted.
A well-known study, “Determinants of Portfolio Performance” conducted by Gary P. Brinson, L. Randolph Hood and Gilbert Beerbower, covered American pension-fund returns. This study showed, on average, nearly 94% of the returns in a portfolio can be attributed to asset allocation, not by timing.
This can also be seen in the DALBAR study. DALBAR is a quantitative research firm that uses data from the Investment Company Institute (ICI), Standard & Poor’s and Barclay’s Capital Index Products to compare mutual fund investor returns to an appropriate set of benchmarks. A recent DALBAR study found that in the 20 calendar years ending in December 2011, The Standard & Poor’s 500 Index had a 7.8% compound return. In the same period, the average investor in US equity mutual funds earned just 3.5%. Investors consistently poured money into the market at the wrong time and took money out at the wrong time. This is a result of investors trying to time the market, whether it’s because of fear or overconfidence. Investors believe they can do what has never been done before. The results empirically show that they can’t.
3. Becoming Emotionally
People invest to make money. Whether it’s capital appreciation or income, investors choose to take some level of risk in exchange for increasing the value of their portfolio or attaining some income. Yet many investors become emotionally tied to a stock either because they work at the company or the stock has given them exceptional returns.
For example, many investors got caught up in the Apple hype and bought the stock when it was near $700. Even the death of the iconic CEO, Steve Jobs, didn’t deter people’s enthusiasm for the stock. The iPhone was responsible for a large part of Apple’s success, but investors to a large degree ignored increasing competition from Google’s Android because they loved Apple. As Apple lost market share to competitors who have caught up with the smartphone innovation that Apple once dominated, the stock price correspondingly fell.
Another example is Enron. In this case, employees had a large portion of their wealth tied up in Enron stock. An outside observer may have noticed the unusual amount of volatility the stock was experiencing, but the warning signs went ignored as the price rose. Eventually, an accounting scandal took the company down along with many retirement accounts.
Mistakes and Missteps
Making mistakes is part of investing. You just need to be right more often than you are wrong. When you do make a mistake, don’t compound the problem and make it worse. Be cognizant of these common mistakes when making decisions and it will likely benefit you in the long run.
by Mitch Zacks, Senior Portfolio Manager. Mitch is a Senior Portfolio Manager at Zacks Investment Management. He wrote a weekly column for the Chicago Sun-Times and has published two books on quantitative investment strategies. He has a B.A. in Economics from Yale University and an M.B.A in Analytic Finance from the University of Chicago.
Disclosure: This communication is for informational purposes only and nothing herein should be construed as a solicitation, recommendation or an offer to buy or sell any securities or product, and does not constitute legal or tax advice. The information contained herein has been obtained from sources believed to be reliable but we do not guarantee accuracy or completeness. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional investment, legal, tax, or accounting counsel.
Leave a Reply
You must be logged in to post a comment.