Investors have blind spots and investment mistakes often become glaringly apparent when completing tax returns in April. Six common investment mistakes are made by both professional and amateur investors:
Mistake 1: Bad Romance–Holding on to an investment for sentimental reasons.
I used to manage money with a charismatic portfolio manager who bore a striking resemblance to the actor from “The most interesting man in the world” commercials! My colleague was an accomplished investor, but he had a subconscious affinity for CEOs with similar “larger than life” personality traits. On occasion, my colleague’s fondness for larger than life characters was detrimental to our investment performance. Here’s an example.
Vivendi was a French conglomerate led by Jean-Marie Messier, a charismatic visionary who had eye-catching plans that often didn’t come to fruition. We owned Vivendi stock longer than we should have, because of the personal connection between Messier and my colleague.
I’ve seen that pattern repeat time and again – frequently among individuals with sentimental ties to companies that they or family members worked for. Sentiment toward a favorite sports team can be funny a thing to poke fun at, but excessive sentiment toward a stock can be financially damaging.
The Mistake 2: Waiting for a Comeback–Hoping to break even before selling an investment.
Investors often hate taking losses on investments, often delaying the sale of a losing investment in hopes that they’ll recoup the unrealized loss. Many times after the technology bubble burst in 2000, investors told me that they would sell their Cisco, Red Hat or Juniper Networks stocks as soon as they recovered their loss.
In many cases, these investors never recovered their loss, and missed out on superior investment alternatives.
It’s reasonable to continue to own a losing position when updated analysis reinforces your rationale for owning the investment; it’s less defensible to continue to own a losing position with no rationale other than “hope” that it will rebound.
Mistake 3: Putting all your eggs in one basket–Concentrating too much of your net worth in a single stock.
Many investors have too much of their new worth tied up in a single stock. I often see this problem with corporate executives who get large stock and option grants, and with individuals who inherit a concentrated stock position from a loved one. Although there are many positive aspects of owning stock in the company you work for, the risks associated with concentrated stock positions often outweigh the benefits.
Employees of companies such as Enron, Arthur Anderson and Tyco lost their jobs and retirement savings when each company had financial and legal difficulties. The financial crisis was hard on employees of banks, and the current energy crisis is hurting the finances of energy company employees.
It’s common to have the illusion of control when owning stock in the companies we work for, but even as an insider it can be tough to forecast major downturns for your company or industry.
The Mistake 4: Mad money–Over-reacting to media coverage, trading too much and trying to time the market.
I remember the days before there was 24 hour coverage of financial markets. I grew up with Lewis Rukeyser’s public broadcasting show, “Wall Street Week,, and used to look at the newspaper to find stock prices for my first investments. In my first experience working for an investment firm, I fielded phone calls from investors calling for stock quotes. I still have memories of a caller my colleagues nicknamed “Mr. AMD,” an investor who phoned us 10-15 times per hour to get an updated price for Advanced Micro Devices stock!
Twenty-four hour coverage of markets encourages some unfortunate investor behavior. Investors trade too much, frequently selling when they should buy and buying when they should sell; all while incurring unnecessary transaction costs and taxes.
Few, if any, professional investors have been successful market timers; for amateur investors a market-timing strategy is even less likely to be successful.
Mistake 5: Following the “rules:”–Following simplistic rules of thumb regardless of personal circumstances.
The “4% rule” is commonly cited as the amount that retirees should draw from their retirement portfolios, providing in theory a steady stream of funds while maintaining an account balance that will last through retirement.
Many variables can influence whether a 4% withdrawal rate is viable, including life expectancy, variability of stock and bond market returns, and the trajectory of medical expenses. The 4% rule may not work for everyone; particularly if we are now in a low-return era for stocks and bonds.
The “100 minus age” rule is often cited as a way to determine how much of a portfolio should be invested in equities. This rule can be uniquely off target, considering rising life expectancy as well as dramatic differences in retirement preparedness.
Rules can be a good starting point for discussion, but shouldn’t be followed blindly.
So if those are the common mistakes you should avoid, what are your other, more rewarding options?
4 Alternative Strategies to Consider
Strategy 1: Develop a plan and stick with it: Determine goals, understand risks, establish a monitoring process and adjust course when necessary.
- Budgets are your friend! Investments may be more fun than managing spending, but a disciplined spending and savings plan may provide more predictable results. In many cases, managing liabilities such as credit card debt can yield a greater return than managing investment assets. In the current investment environment, paying off debt with interest rates of 10% or higher may yield a better return than investing in stocks or bonds.
- Follow a systematic investment approach. Emotions can be the enemy of investment success. A strategy that incorporates regular investments, periodic rebalancing to target weights and avoiding emotionally driven decision-making is more likely to succeed.
- Diversify your portfolio. A diversified portfolio generally offers a better balance of risk and return than concentrated strategies. Diversification among stocks, sectors and countries may be the most reliable path to reaching financial goals.
Strategy 2: Avoid silent killers: Costs are much easier to control than investment performance. High costs and high turnover can create a high hurdle to clear for investment success.
Strategy 3: Simplify: The best solutions are often the most simple.
- Avoid investments you don’t understand I’m skeptical of many leveraged ETFs that are only suitable for short-term trading strategies. I’m also wary of quantitative strategies that can’t at least be explained in conceptual terms to a prospective investor, and that have nothing more than a theoretical back-tested track record.
- Don’t go overboard diversifying your portfolio. I remember one investor who came to us with about 30 stock holdings, 50 mutual fund holdings, and 10-15 ETFs. Counting underlying positions within the mutual funds and ETFs, I think he owned about 30,000 positions, far more than needed to properly diversify his portfolio! A portfolio of that complexity can be unwieldy and expensive to maintain. There are often much simpler approaches that will yield better outcomes.
Strategy 4: “When the facts change, I change my mind”: In a quote commonly attributed to John Maynard Keynes, “When the facts change, I change my mind.” Investors should constantly “test” their investment point of view – reviewing whether to alter investment positioning based on new information that changes the outlook for the investment in question.
Historical performance is not indicative of any specific investment or future results. Views regarding the economy, securities markets or other specialized areas, like all predictors of future events, cannot be guaranteed to be accurate and may result in economic loss of income and/or principal to the investor. Nothing in this communication is intended to be or should be construed as individualized investment advice. Securities mentioned are for illustrative purposes only and do not represent securities bought or sold by Adviser for its clients.