05 May Common Mistakes Investors Make - And How To Avoid Them
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As human beings, we like to think that we’re rational thinkers, making decisions based on logic. The evidence however overwhelmingly suggests that, when it comes to investing, we are far more likely to be driven by our emotions.
Human beings fight a constant mental battle between their reflective and intuitive minds. Making hasty, emotion-driven, investment decisions is proven to destroy wealth unnecessarily.
One of the most often cited investment tips is ‘Never follow the herd’ but when we let our emotions rule our way of thinking that is exactly what we do. ‘The herd’ is guilty of making a number of behavioural mistakes which are repeated seemingly ad infinitum as the years, and market cycles roll on. Below are the most common of these behavioural mistakes, and – crucially – why you should avoid making them:
Under- (or over-) diversification
‘Asset allocation [the mix of your investments] is not a panacea. It is a reasoned – if imperfect – approach to the inevitable uncertainty of the financial markets.’
John Bogle, founder of Vanguard
The future is uncertain and nobody has a crystal ball that can accurately predict what it holds. This is never truer than in the investment markets. It doesn’t take a genius to work out that placing all of one’s investment eggs in one basket (or just a few baskets) makes little sense. Diversification is simply good practice and should be employed widely in any investor’s portfolio.
Diversification takes place at several levels.
The first is that as a (partial) owner of a company the value of your investment is beholden to the specific fortunes of that company. Owning a broad number of companies in the same sector can smooth returns but every sector faces its own sector-specific risks so it makes sense to diversify further by owning the UK equity market more broadly.
Remember however that the UK is less than 10% of the global economic output (and market capitalisation, i.e. the value of its stockmarket) and it therefore makes sense to have a material allocation to other developed and emerging markets too.
Equities, while expected to deliver higher returns than bonds, deliver no certainty that they will do so although the odds improve the longer they are held. Diversifying part of your portfolio away from equities and holding other assets such as bonds also makes sense.
It is also possible to be over-diversified, in that you can own multiple assets which, while appearing to spread your risk, actually do nothing of the sort because they perform similarly to each other (for example, a portfolio of shares in 100 technology companies would have experienced very similar returns in the tech crash of 2001).
Similarly, the more investments you own, the more paperwork is generated and the greater the opportunity to pay higher costs and taxes from trading between them. A single globally invested fund with 3,000 holdings may be better diversified than a portfolio of 30 individual companies.
Is your portfolio well diversified at all levels? Remember that owning a number of funds does not necessarily mean your portfolio is diversified. Look through the fund structure at the underlying investments to see if you are diversified broadly enough.
Euphoria and panic
Human beings are all afflicted with minds that battle between being reflective and being intuitive. Unfortunately, with an investor’s hat on, the intuitive wins on many occasions, resulting in panic and elation as markets fall and rise respectively. If the intuitive mind dominates in making investment decisions, then investors risk damaging their wealth by buying at the top in a state of euphoria and greed and selling out at the bottom in blind panic.
The difference between the published return of a fund and the return an investor receives (which depends on when they enter and exit a fund) illustrates whether investors are good or bad at timing markets. The evidence is that, across the board, investors are overwhelmingly bad at doing so, giving up somewhere between 1% and 3% a year compared to the returns of the funds they own[1].
(Reproduced with kind permission of Carl Richards – www.behaviourgap.com)
The key to success lies in a number of areas. The first is to own a portfolio that is well diversified across markets and asset classes. The second is a clear understanding of the journey and acceptance of the fact that it will often be two steps forward and one step back and occasionally two steps back and one step forward.
Finally it is about putting in place an investment process that mitigates some of the sources of leakage from the portfolio due to emotional (rather than rational) decision making. This includes rebalancing of portfolios back to their original mix on a regular basis, which entails selling out of assets that have performed well and re-investing in assets that have performed less well – a systematic and contrarian investment process that enforces a ‘buy low, sell high’ approach.
Accept that you are prone to emotional pressures that drive you to do the wrong thing at the wrong time. Learn to be comfortable with the diversified portfolio that you own. Lean heavily on your adviser when you need support at times of emotional investment-related weakness.
Speculation
There are no dead certainties in investing apart from the fact that any product that appears to deliver great returns with low risks has a high chance of disappointment – usually in the form of a material reduction in the value of your investment.
There are two main types of product that fall into this category: a fraud wrapped up in a good story and a bet wrapped up in a good story. Beware the snake-oil salesman. The Ponzi scheme fraud perpetrated by Bernard Madoff was a classic case of someone with the ‘gift of the gab’, a semblance of credibility, a complex purported strategy that few investors understood and an air of exclusivity and secrecy.
Those who were taken in were not stupid – achieving success as a confidence trickster requires good powers of persuasion and even the intelligent and highly respected can be fooled.
The second is usually something that sounds so fantastic that you get sucked into the upside and blinded to the risks. Remember – if it sounds too good to be true, it probably is.
If you get excited about a specific opportunity, stand back, take a deep breath and ask yourself where the catch is. Return and risk are always closely related. Ask yourself why, if the opportunity is so great, is someone trying to sell it to you? Surely they would keep it all to themselves. Remember that the investment world is full of great story-tellers.
Investing for yield
If you choose equity investments which have a high yield to meet your regular expenditure then you greatly increase the chances of running out of money in your lifetime, because this approach is likely to mean that you choose to invest only in securities or funds that pay higher than average dividends. As a result, you may miss out on the many world class companies which either pay no or very low dividends but whose share prices can appreciate greatly over time.
You should also bear in mind that high yielding shares pay that higher yield for a reason – generally it is an indication of a company whose share price is underperforming for some reason. Whilst the fortunes of the company may improve, higher yielding shares generally carry a higher level of risk to your capital (remember: when it comes to investing, diversification is the only free lunch).
In your fixed income exposure, chasing higher yields may mean that you end up with a significant exposure to holdings which are highly vulnerable to considerable capital losses when interest rates rise (as they must eventually from their current historically low rates). In broad terms, a basket of bonds with a 10-year term until maturity will suffer a 10% fall in capital value for every 1% rise in general interest rates.
You might also be seduced into buying structured products which purport to offer a market-beating return as long as one or more market indices or individual securities does not fall (at all or by more than a certain percentage) over a set period. These products are generally created by institutions to meet their own requirements and the other side of the trade is what is then offered to the private investor – being the counterparty to a product created by bright professionals in investment banks for their own benefit is not necessarily going to be the best way to invest for YOU.
A ‘total return’ approach delivers an income to the investor from dividends and coupon payments and makes up any expenditure gap from capital. The main advantage of this approach is that it allows the portfolio to remain properly diversified, rather than becoming concentrated around credit risk in bonds and increasing sector- and company-specific risks in equities. The risk level of the portfolio is also maintained where it should be; where it matches the investor’s own preferences and needs.
While there are no absolute right or wrong approaches to investing, there are certainly some solutions that are preferable to adopt. Chasing ‘natural yield’ tends to trade income today for the material downside risks outlined above.
Letting tax dictate investment decisions
The most tax efficient investment is one which produces no income and which loses money. Any product advertised as such would presumably have few takers, yet time and again investors choose to invest on the grounds of tax-efficiency rather than looking at the overall risk and return.
There are undoubtedly a range of useful tax wrappers which have a place within a diversified portfolio but their tax treatment should not be the biggest determining factor in whether to make the investment or not.
Never let the tax tail wag the investment dog.
If you can avoid making the above mistakes on your investment journey you greatly improve your chances of having a successful investment experience, and reducing your levels of stress!
Carolyn
[1] Phillips, D. (2011, October 15th), Five lessons from 25 years. (Business & Wealth Management Forum, Interviewer) Morningstar