Who is looking out for you?
Let’s face it, the battle for your investment dollars rages all around us. This battle is fought on TV screens, the Internet, in print and on the radio. Two vastly different forces are battling against each other.
One force is led by the financial industry at large: brokers, planners, TV personalities and other so-called experts. The other force is led by the academic world and has generated Nobel Prize winners.
The goal of this chapter is to educate you in what the vast majority of investors don’t know. In other words, I want you to know the truth. My goal is to help you create your own investing game plan for success and avoid the disastrous mistakes made by most investors, which are routine and commonplace. These mistakes not only rob you of the growth you seek, but also your sense of well-being by creating stress and anxiety in lives of the people who make them.
The unfortunate but real truth is that most investors do fail. Dalbar research reports the average mutual fund investor earned only 2.6% per year from 1984 through 2002. The typical investors left to their own devices or the self-interested advice of their brokers fail to even keep up with inflation, much less achieve their desired market rates of return.
The majority of financial and investment advice is generated to produce the illusion there are so-called “experts” who can supposedly tell you how to beat the market. Many people want to believe this advice because they want to keep the false hope alive that they, too, can beat the market by following these recommendations.
The financial press is based on fear and greed. All we ever hear is their predications of what is going up, what is going down, and why you should buy or sell now. How do they know? The truth is they don’t know, but guess what? They make money either way.
We see and hear these so-called experts everywhere: on TV, in the paper, in magazines and news financial programs. The problem is if you believe them they can inevitably cost you your life savings. No one can give you a guaranteed forecast of market or individual stock movements, yet the industry leads you to believe they have some special formula to outperform their peers and if you follow their advice, your pot of gold is just on the horizon.
The following is a short list of some of the most common investment mistakes made by investors often on the advice of their advisor. They are called common because that’s what the financial industry has been preaching to you for decades. The truth is, trying to “beat the market” doesn’t work. Many investors follow this advice because this is all they have ever heard. Indeed, this is what the financial industry wants you to hear because it generates millions of dollars in commissions and fees for their firms.
1. Trying to pick the best stocks
What’s the next hot stock or group of stocks going to be? When you invest on the advice of a broker or media person’s recommendation regarding what specific stocks or mutual fund to own, you’re gambling. Studies show as professionals attempt to out perform the market, they actually under perform it, which in effect causes you to lose money. Still the financial industry is relentless in propagating if you just follow their advice, you can earn a superior return.
2. Trying to time the market
What is unique about the future? It’s unknowable. No one is ever able to tell when the next tsunami is going to hit, or if oil is going to spike because of some unseen circumstances. Even if you do not believe you can or want to time the market, your mutual fund manager is most likely attempting to do so without your knowledge. The average mutual fund turns over about 100% per year according to Morningstar, John Bogle and others. This means that if you buy a mutual fund on January 1st, by December 31st, it may not have even one of the same stocks. You might be a long-term investor but the people you hire to manage your investments probably buy and sell everyday. They are consequently acting as market timers with your investment dollars.
3. Track record investing
Track record investing entails betting on the past performance of a money or mutual fund manager, much like betting on a horse that had stellar performance in the past. Your advisor is likely to indicate they or his firm has the ability to find managers who have done well in the past and therefore they will do well in the future. This thought process is simplistic, which is perhaps why it is so appealing.
Statistically speaking, money managers in the current top 25% of performance are just as likely to be in the bottom 25% in the future. Here is the sad truth: a mutual fund manager may have one, two or even three PhD economists, five or six CFAs (like masters in investing) and fifty or sixty others on staff. Still, they consistently under perform the portion of the investment market they are trying to beat.
Here is a little secret: every mutual fund manager has a “benchmark” with which they compete. For example, a manager who manages a large cap stock fund will have a benchmark such as the S&P 500, which includes 500 of America’s largest companies. This is what they don’t tell you - they routinely under perform their benchmark. You would have done better by directly investing in the same benchmark they try to beat while also saving all the fees and commissions.
4. Thinking you are diversified
Many investors believe that they are diversified if they have a lot of items on their statement. Many Americans fell into this trap in the early 2000s through the advice of brokers, planners and the media when portfolios were loaded up with large cap American and technology stocks. The result was painful for many. Why? Because stocks that are in similar sectors of the economy often move together. If you have lots of items on your statement all in the same sectors, you are not diversified. The largest, supposedly safest U.S. stocks (as a group) lost over 43% for the three-year period starting January 1, 2000. Even today, many investors continue to hold more than 50% of their portfolio in large US stocks.
When is the best time to make a good decision? Most investors respond “now” is always the best time to be making good decisions … and they’re right. Unfortunately for many investors it is easier to make a bad decision worse by continuing the destructive process rather than facing it. The longer you speculate and gamble with your money, the more it can cost you. The opportunity here is to realize that you are not your decisions - just because you made an ill informed decision based on what you knew at the time, does not mean you are less of a person or less intelligent. As a matter of fact, it’s a sign of intelligence and growth to put an end to a destructive process when you become aware of it. Here is the bottom line - the longer you speculate and gamble with your money, the more it will cost you.
What is behind the curtain?
Symptoms of investment mistakes:
Symptom One: Doubt
This is when you have a gut feeling something is wrong or something just doesn’t fit. Are you continually second guessing yourself, your broker or your planner? “Maybe I shouldn’t have done that, maybe I shouldn’t have bought this…is the market going up? Is the market going down? Maybe my broker is not giving me the best advice…maybe my financial advisor is wrong.” When you find yourself constantly wondering and worrying if you are doing the right thing, you have a symptom. You need to “know” what you are doing is correct for your situation. If you don’t, get different advice.
Symptom Two: Big Losses
No matter how careful your market investment decisions, you’re always going to have some negative returns. When you experience losses in your portfolio of 20%, 30% or more, chances are you’re experiencing the effects of an investor mistake.
I have found investors who suffer from this symptom are amazed and stupefied that their portfolios could lose so much money. They often have been led to believe they were conservatively invested and well diversified. Unfortunately, many investors found out the hard way they could actually lose more than they could ever imagined. Their advisor said “risk must be considered” but they were never given a means to measure and understand the risk they were taking. Even worse, their advisor often does not understand risk and diversification themselves.
Symptom Three: Complexity and Confusion
Investors often receive multiple brokerage statements, or one big confusing brokerage statement that is difficult to understand. They cannot tell what was bought, sold, what the real mix of their portfolio actually is and for that matter, what their actual rate of return truly is. Many investors feel their statements are intentionally designed to confuse them.
Symptom Four: Broken Promises
If you were led to believe you would experience stellar performance and you didn’t, the natural human emotion is ANGER. If your investment advisor stressed the gains you could make while downplaying or whitewashing the very real possibility of losses you could suffer, you have every right to be fed up!
Symptom Five: Unnecessary Tax Burden
This is one of the most difficult investor mistakes to understand and analyze. The average American stock-based mutual fund, according to Morningstar, has an annual portfolio turnover in excess of 100%! As stated before, this means if you own many mutual funds on January 1st, you may not have one of the original stocks the fund owned by December 31st. All stocks in your fund have been sold and replaced by another “supposedly” better stock. This means your “long-term” investment portfolio is virtually selling every stock once per year and buying brand new ones. This can generate tremendous tax consequences. You can actually lose market value in a mutual fund and still have to pay taxes because of all this trading, not to mention the additional trading cost you must pay.
By now you may realize you have made some investor mistakes or at least feel some of the symptoms. What do you do about it? Here is the best answer I know.
Three simple investing rules anyone can follow:
1. Own equities
(Repeat until you die)
Simple isn’t it? No, not quite. The problem for most investors is not natural intelligence, but acquired knowledge. Sir Isaac Newton is certainly one of the most intelligent people who ever lived. Newton invented calculus which is the form of math rocket scientists use to send astronauts to the moon. Most people don’t know that Newton lost most of his net worth on what was called the “South Seas Bubble”, which is the equivalent to the dot-com bubble of our day. The problem many current investors face is they don’t have the right kind of knowledge; instead, we encounter information overload compounded with our own emotions and instincts.
Facing the light.
Most investors are hard wired to fail because man’s most basic instinct is to avoid pain and pursue pleasure. Why? Because events we encounter which are painful such as hunger, cold, physical trauma are actions that endanger our lives. On the other hand things that are pleasurable warmth, love, and eating when taken in balance, tend to help ensure personal survival. We are programmed to move toward pleasure and away from pain.
Good investing habits are not painful; however, they do involve learning something new. You may need a new advisor and you must certainly stop listening to the financial press.
Stop Stock Picking, Market Timing and Track Record Investing. Stop gambling with your investment capital!
Determine what return you would like to receive and remember, the higher the return, the higher the risk you take. Consequently you must also determine how much risk you are willing to assume. In other words, determine the balance of the return and risk with which you are comfortable and then build a portfolio that meets those criteria. How do you do that? Put together a portfolio that is extremely well diversified. A portfolio that consists of large asset classes and fixed investments: not individual stocks, bonds or (mutual funds for that matter) at the lowest possible cost. How do you do that? The best way to succeed is to become an expert by reading, studying and observing how wealthy investors, large pension funds and large private and public trusts invest or consult a professional planner who understands and adheres to these principles.
What you can achieve!
The result and reward of good planning is peace of mind. It’s true - the reward at the end of a good portfolio is peace of mind. Once you put together the best overall strategy for your situation that achieves the returns you seek with the least possible risk at the lowest possible cost, you can relax. Like a well-oiled machine, you can stand back and let it run, only tinkering with the works when you experience a change in your life. Life has enough to worry about - one less concern is a good thing!
Next Chapter: Taxes