Avoid These Common Investment Pitfalls
|July 18, 2013||Posted by Nat Stewart under Investment Philosophy||
Long term investing success is as much about what you don’t do as it is about what you actually do. Without writing a treatise on the subject, I wanted to list out some of the big pitfalls that I believe plague most investor’s performance. Many of these are hidden and hardly covered by the financial media.
- Perhaps the top “hidden” error is what I call, “The money weighted return problem.” Everyone has seen the exiting “headline” returns touted by stock market, mutual fund, or ETF promoters. Well, in the real world, this is not what investors actually earn on their invested capital, and this is for a simple reason: These figures do not take into account when investors time their actual investments. Investment timing has a profound effect on real-money returns. Research has shown that the average investor underperforms their own investment choices by something like 2% per year. If you have ever felt alone in your urge to “buy the highs and sell the lows” you can know with certainty that you are not alone. “Buying high and selling low” is precisely what most people do with their real money, and it kills investment returns over time.
- Many investors have been sold on the idea that “high risk” investments are needed in order to give one a reasonable chance of having higher long term returns over time. More risk = more return. It is a nice theory, isn’t it? The problem is that in the real world, it is doesn’t work. Objective evidence has demonstrated that outside of a very few limited circumstances, high risk investments have worse average returns than more conservative investments of the same category (Low risk stocks vs. higher risk stocks, etc.). This concept was proven to my satisfaction by Mr. Eric Falkenstein, who wrote an excellent book on the subject. In the real word, sticking with “boring” or “conservative” investments actually increases the expected return for all but the most informed investors.
- Perhaps the greatest performance destroyer for most investors is excessive portfolio expenses. This category includes management fees, excessive trading costs, and excessive tax exposure. I have read that the average mutual fund turns over its portfolio something like 70% a year. In my opinion, this behavior is ludicrous. 70% turnover in a huge portfolio with no documented trading edge is insanely foolish. With very, very rare exceptions, I would avoid all mutual fund products.
Fortunately, these basic errors have fairly easy solutions, each of which can make a world of difference if implemented with some discipline:
- Don’t over-invest! Many people struggle to stay invested because they are investing too much in the first place. If swings in stock values cause your heart to flutter, it is likely that you are over-invested relative to your personal psychological comfort zone and relative to the rest of your financial picture. For example: Having a “cash cushion” to meet unforeseen expenses, etc. Is very important.
- Understand your time horizon! Many investors are not clear on what the real, accurate time horizon is for their investments. If you believe you are a “long term investor” yet at the same time want easy access to your full invested principle amount at all times, your basic plan has an internal conflict that will almost certainly lead to errors in judgment at the worst possible moment. I wrote an article about this at my trading site which can be found here.
- Eliminating debt can be your best investment! A friend once asked me if I knew of any good stocks for him to consider investing in. This same friend had previously told me that they had a substantial amount of credit card debt that was charging an exorbitant interest rate. This, folks, is a no brainer! The best, surest investment for someone in this situation is to put all surplus funds into paying off the high interest rate debt!
- Own a portfolio of businesses, not “Financial products” or “the stock market!” Long-term investing works because investors have the opportunity to earn cash flows that derive from real businesses in the real economy. Mr. Market tends to fluctuate far more than underlying business values do – If you understand this it might be easier to hold through more difficult periods.
- Avoid high risk, “lottery ticket” style investments! This is very important advice for 95% of all investors. It has been proven that on average, “high risk” investments have terrible performance characteristics over time. Not only this, but most people exacerbate the problem by doing a poor job of timing volatile, risky investments (buying high and selling low).
- Avoid portfolio turnover to the extent possible! Excessive trading creates all kinds of long-term performance problems for the vast majority of Investors. Commissions, market impact, and taxes are all created by excessive portfolio turnover. If you have chosen your investments wisely, premature selling also disrupts the compounding process. J. Bruce Flatt, CEO of Brookfield Asset Management, explained it this way in a letter to the shareholders of General Growth Properties: “…The premium received in the short term does not compensate for the disruption of compounding returns over the longer term”. I have considered that statement more than a few times since I first read it last fall.
- Always consider tax efficiency! If you do decide it is time to harvest a large gain, check to see if you have any unrealized losses in investments that could re-allocated in the same tax period. Compounding the gains of tax efficiency over time can make a big difference.
- If you are going to trade or use speculative strategies with “long-term” investment money, do it in a tax advantaged account if possible! This one is a no-brainer.
Those of you who know that I also run a trading-related site might be perplexed by some of the above recommendations. Am I contradicting myself? The resolution to this paradox is actually quite simple:
The ideas that I have listed above could help a large amount of people improve their investment performance. This is because investing for the long term allows people to profit from overall economic growth and the productive cash flows that derive from the “real” economy.
Trading, on the other hand, is not this way. Successful traders get an edge by winning money from people who are making less rational decisions in the marketplace. By its very nature, the trading approach to managing assets cannot work for the majority of people, and never will. For example: If the majority of people discovered and used a good strategy, it would stop working. Everyone can’t be on the same side of the see-saw at the same time and then expect it to go up.
Given the above, my favorite time to buy a long-term investment is when I believe other investors are over-reacting to short-term information and have driven the price down. I particularly like it if I have reason to believe that some of the selling is a result of margin calls from over-leveraged speculators.
I have a portfolio of stocks that I follow and look to accumulate when these situations develop. While these timing techniques would not work if everyone used them, I believe that they continue to highly useful – emotional selling and over-leveraging will not be going out of style any time soon.
By the way – I am not going to be doing many articles like this. Sometimes these basic questions come up, and I wanted to have an article to refer people to. Also, keep in mind that the above article constitutes my opinion and is not investment advice.