SCOTT FRANCIS – 7 OCTOBER 2013

Summary: There’s no formal rulebook for investing, and a large number of investors taking to the investment field are often playing blind. They may score some goals along the way, but without a disciplined approach it’s more often luck than skill. Here’s a list of the five most common investor mistakes, and what to do to avoid making them.

Key take-out: Learning from the mistakes of others is a good investment education process, whether it be lessons in market timing, switching investments, holding losers, or responding to recent events.

Investing is not an easy thing, and choosing how we expose our money to capital markets is challenging.

How do we find the correct balance between risk, return, liquidity, asset allocation and diversification? How do we need to change our decisions over time? What are the key financial goals that we have?

Self-managed super fund investors are required to have an ‘investment strategy’ – one of the things that I think legislation around SMSFs has got correct. However, I don’t think this process should only be for people with SMSFs – it is something that every investor should think about. In this article I want to touch on five mistakes that we tend to make as investors, in the hope of avoiding them in the future.

I have tried to put them into their order of magnitude, starting with the most significant, however I am sure that everyone will have their ideas on which are most significant.

Mistake 1 – Market timing

Market timing refers to trying to pick which asset class will perform better in the future, and moving money accordingly. It seems, however, that as investors we tend to get this process completely wrong. When the environment is full of bad headlines and shares have fallen sharply in value – think early 2009 when markets hit their GFC lows – we tend to want to avoid shares. Similarly, when the media is full of ‘record highs’ and attractive historical returns – think the end of 2007 before the start of the GFC – we tend to favour shares as an investor class.

Investment guru Warren Buffett cautions about exactly this type of behaviour, encouraging us to be “greedy when others are fearful (2009), and fearful when others are greedy”.

Dalbar, a US-based financial services firm, tracks the way money flows into and out of sharemarket managed funds to calculate the return that real investors experience. In the 20 years to the end of 2012 the average sharemarket return in the US was 8.2%. The experience of the average managed fund investor was a woeful 4.25%.

We have all seen the data about how long-run average returns from the sharemarket turns modest sums into impressive piles of cash – so long as we stay out of the way and let the markets do their work.

Mistake 2 – Switching between companies

Researchers Barber and Odean (2001), in the Quarterly Journal of Economics, look at share trading behaviours between men and women. It is a fascinating experiment based on the trading activities of 35,000 portfolios from a discount broker.

I think that there are two fascinating findings from their studies – the first being more of an interesting comment from Gallup poll research, which asked people about what return they expected from their portfolios over the next 12 months? Men expected to beat the average market return by 2.8%, and women by 2.1%. It must be nice to be confident that you are so much better than average.

The study found that trading was a drag on performance – investors would have been better off without trading. Trading reduced the returns from men’s portfolios by 2.65 percentage points a year, and women’s portfolios by 1.72 percentage points.

Mistake 3 – Holding losers and selling winners

Another interesting tendency of investors is the selling of winners from their portfolio, rather than poorly performing shares. In a 1998 Journal of Finance paper, Terrance Odean looked at this phenomenon. There are reasons that a person might want to sell winners – for example, selling down a holding that had become disproportionately big in a portfolio. Odean eliminates these factors in his paper, and finds that there is an irrational, and financially damaging tendency to be prepared to sell winning investments, but wanting to hold the losers until they ‘came good’, or got back to ‘break even’.

This mistake even has a name in the research, “the disposition effect”, and is something investors should think about.

So what happens in this study after the shares are sold? In the portfolio, after winning stocks are sold, they go on to have an excess return (compared to the market average return) of 2.35%. The ‘losing’ stocks that are retained in the portfolio have an underperformance of 1.06% over the same period. The conclusion – investors would have been better off selling the losers and keeping the winners.

Of course, this is all before tax. Taking into account the capital gains tax paid on the sale of the winning shares makes the ‘selling winners and holding losers’ strategy even less attractive.

Mistake 4 – Overreacting to recent events

This is another area of research pertinent to the current investment climate. It finds that people who, early in their investment life, experience good sharemarket returns tend to disproportionately favour them as an investment. Conversely, people who experience poor sharemarket returns early in their investment life tend to avoid them.

Both of these factors lead to potential issues. Overexposure to shares following a period of good returns leaves an investor more vulnerable to the downturns that we see in markets – such as in the early 1970s, 1987 and during the GFC. Conversely, investors who avoid shares and stick to cash-like investments with lower returns struggle to counter the impacts of inflation.

Mistake 5 – A too narrow focus

Diversification is key in any investment strategy, but often investors build up a portfolio that is too concentrated in one area. For example, in the hunt for yield, investors have flocked to the big banks, in some cases buying holdings in all four. They have done this without taking into account factors such as sector risk (the risk of contagian across the banking sector, should economic conditions change suddenly) and the opportunities available in other areas of the market, such as in resources companies. When building an equities portfolio, it's important to spread the risk to capitalise on the growth potential of different areas, and to create a buffer against changing market conditions that may impact other sectors.

Conclusion

Investing is not easy, but a written investment strategy is something that might benefit most, if not all, investors. One thing we can all do is consider the research that might allow us to learn from the mistakes of others, whether it be in market timing, switching investments, holding our losers, or overreacting to recent events.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.