Experience is the best teacher, but when stocks and shares are involved, it’s definately profitable to learn about mistakes made by others rather than making them yourself!
1. They don’t diversify properly
‘Don’t put all your eggs in one basket’ is a well-known maxim, and one that is firmly practised by finance professionals, whether they’re pension fund managers, mutual fund managers or even day-traders.
New investors mistakenly take this to mean that they should simply invest in over 50 stocks and shares to tick the ‘diversification’ box. This is wrong. Diversification means so much more than that.
Diversification means smoother returns = less risk
Some new investors get it half right; they appreciate that they should invest in as many different industries as possible to lower the risk of a single industrial event (such as a plane crash) effecting their whole portfolio.
Some investors go even further towards the correct path, understanding that they should be also ensuring that the companies are of varying sizes, which will help negate the effects of regulation and other factors that would effect companies of a certain size.
The investors who did a little more research will know that ensuring a good geographical spread of investments will further help to balance their portfolio and smooth out events effecting certain countries in particular.
However, even these investors are missing a good opportunity to diversify their portfolio and reduce risk. This opportunity comes in the form of the alternative asset classes.
Alternative Asset Classes are types of investments other than bonds and stocks & shares. These include real estate, commodities, and exotic options such as art, fine wines and other collectables.
Alternative asset classes have positive expected returns, but their gains (or losses) will be very out of sync with the stocks in your portfolio. This is great for diversification, and represents a chance to really smooth out the ups and downs in the stock market, and produce a more consistent return each year. Alternatives only need to make up a small part of your portfolio to have a positive effect.
Read more about the simple science of diversification.
2. They expect mutual funds to outperform
Here’s a shocking truth that some investors need to realise: as a group, mutual funds do not provide higher returns than the market average, after fees. Studies have shown that 75% of mutual funds actually under-perform the benchmark index that they’re supposed to beat, after taking fees into account.
Why is this? Are they making poor investment decisions? Or are they conspiring to trick us investors? Actually, the answer is neither. It’s all in the numbers.
The unfortunate truth is that asset managers – professionals who manage other peoples money – control well over half the money invested in the stock exchange. Whether it’s through pensions, unit trusts, mutual funds or hedge funds, the majority of the markets value is controlled by professional investors aiming to beat the market. Yet by definition, only 50% of participants can ever achieve a higher-than-average result. After taking their fees into account, many of the managers who have only marginally beat the market, it turns out have actually underperformed it. This leaves the remaining 25% that have actually enhanced value for their clients.
So, does the mutual fund option appear attractive now? You have either a 25% of ‘winning’, 75% of ‘losing’. The numbers say that you are 3 times more likely to under-perform than over-perform. It’s a losers game. You probably chose mutual funds in the first place because you didn’t want to be making the difficult decisions that will determine the returns of your portfolio, but with mutual funds – you’re still left with those difficult decisions – which funds to invest into!
In contrast, one can invest directly in a market index’s constituents (such as the FTSE100) through a cheap and passively managed index fund, which aims to match the market return. With small fees of typically less than 0.3% per annum, clients can virtually guarantee that they match the market everytime, and beat the majority of ‘expert’ asset managers in the process!
3. They view gold as a ‘safe’ investment
The Unsafe Haven
Gold is revered in the financial media as a ‘safe haven‘ for investors. Inexperienced investors often confuse this term with a ‘safe investment‘. A ‘safe haven’ protects the investor against the adverse effects of a certain ‘risk”, but that ‘risk’ isn’t always ‘absolute loss’. Gold actually protects an investor from ‘inflation risk”. This is because it is a material, and therefore if inflation rises, then so must the value of gold, and hence the investor has not seen their wealth eroded. But no guarantees are provided over the other risks such as pricing risk (the risk that the value of a security may decline in value). Gold is susceptible to violent market volatility just like any other commodity. While gold (as of writing) currently stands at an all-time high of $1,400 – it could fall by 10% tomorrow and take a chunk of your investment with it. On its own, gold is a risky investment. It only has a place as a small part of your investment portfolio. I explore more common gold myths in a dedicated article.
4. They avoid using ‘fee-only’ Independent Financial Advisors
‘Fee-only’ financial advisors charge often sizable amounts to advise or manage your portfolio. This is in contrast to ‘Commission’ advisors who sell you financial products on which they earn a similar commission on the back end. Both actually cost similar amounts, but the commission-based advisor has an incentive to refer you to the highest paying fund, rather than the fund that is most suitable for your own needs. Make the intelligent decision to engage a ‘fee-only’ advisor, who only has an incentive to provide good advice!
There is also the problem of investors avoiding IFA’s altogether. Read Do You Need a Financial Advisor? to learn more about that mistake.
5. They then seek advice from terrible sources
After avoiding financial advisors that will work in their best interests, the average new investor also take advice from sources that they really shouldn’t.
a) Buying ‘penny’ stocks or shares of very small companies after reading online recommendations. (These are usually written by the owners of those stocks, who will sell after the stock receives a nice boost from the increased demand for the shares).
b) Trading based on pundits on financial TV channels. Pundits are renowned for practically arguing in every direction at the same time. One day a pundit will contest that the index has a long way to rise yet, and the next day they’ll be outlining why the index is over-valued. Don’t let your investment strategy be determined by the ‘lottery’ that is which interview you happened to watch, or which article caught your eye in a financial newspaper column.
c) E-books that claim to guarantee extraordinary profits
6. They buy index-linked bonds
An index-linked bond offered by a bank will typically look like this: At the end of a 5 year term, the bond will pay the holder 2% interest, as well as up to 25% of any cumulative gains on the FTSE100.Such products may first appear to be a useful opportunity to gain exposure to rising share prices, but they’re universally a bad investment. Why?
The answer lies in this statement on the Natwest website: “As you do not invest directly in shares, you will not receive any dividend payments”. As an investor, when you hold shares you get two types of gain, and one type of loss. You can earn dividends AND earn a capital gain, or you can experience a capital loss. With index linked bonds, you receive the same probability of capital gain or loss, but you don’t have the very handy ‘always positive’ dividend payment tipping the return more in your favour. In other words, the dice are weighted against you.
At the end of the day, these bonds will deliver poor returns compared to an investor who has invested part of his funds in cash, and part of his funds in the actual stock market. These are high margin products upon which the bank will make a profit. In comparison, the stock market option gives you direct access to 100% of the profits of your investment, with just a little more effort required on your part. In fact, using various financial instruments and a little bit of know-how, you can actually construct a DIY bond that exhibits exactly the same behaviour as an index bond, except with more profit!
7. They let the wrong reasons guide their investments
Not all days are good days
As humans, we cannot help our sentiments direct our thought processes. However the difference between a good and bad investor is whether or not we let it effect our investment decisions. Common examples include:
a) Selling shares after bad news. (If the news is already public, then the market will have reacted anyway, and a loss will be unavoidable. You should only sell if you believe that the news is actually worse than the market has adjusted for).
b) Holding too much cash. Sometimes the fear of missing an opportunity causes people to hold far too much of their assets in cash, when that cash could be working harder for it’s owner invested in stock.
c) Buying after a period of excessive gains, also known as ‘jumping on the bandwagon’. This occurred heavily in the dot-com boom and the period before the great depression. Buying a stock because you blindly think it will rise based on past performance is foolhardy.
d) Marketing materials of investment funds. If your opinion has been consciously altered after reading a fund prospectus, then jump online and Google around to ensure that you’re aware of the negative views on the fund as well as the bullish ones, so that you can make a fully informed decision.
e) Buying on the recommendations of our friends. It may be tempting to be swayed by the decisions (and perhaps previous successes) of our friends. We experience a natural urge to do as others do around us. You may have to fight against this instinct, in order to protect your carefully-crafted portfolio from becoming studded with random ‘hot picks’ from trusted colleagues.
8. They hold onto losers and sell winners.
Investing successfully takes courage. I’m not talking about the courage to sell out of a winning position that may in-fact rise further, but the opposite – the courage to resist the temptation to capitalise a gain too soon. As a investor, you need to be comfortable with risk. What you will often see is people buying a stock and selling as soon as it makes a small profit, just to satisfy themselves that they aren’t a ‘gambler’ or ‘greedy’. While they may applaud themselves as a wise and balanced invester, the policy of ‘cashing out’ immeadiately after a gain is a truly foolish decision.
If you look back at the historical performance of stocks over the past decade, some have made 140% gains within a year. You may look at that and think ‘wow, I wish I’d picked that stock’. But look at yourself hard in the mirror as ask yourself ‘If I had in-fact bought that stock, wouldn’t I have sold out as soon as you hit a 20% profit?’ This clearly shows that to actually benefit from upswings, you need to hold stocks over the longer term and not sell simply based on the amount of profit you have made, otherwise you’re capping your potential gains in the good years.
On the other hand, you also have investors who refuse to sell out of loss making positions, and maintain these ‘dead cows’ on their portfolio for several years in a hope that things will pick up again. You should be confident about every investment in your portfolio. Rather than deciding whether to hold on, or to sell a current holding, you should be thinking ‘would want to I buy more of this investment right now?’. If you aren’t confident enough to put extra money into that stock or fund, then why are you holding onto it at all?
An extra side effect of selling winners and holding onto losers is from a tax perspective. This mistaken strategy actually maximises capital gains tax, because you’re incurring gains as soon as possible, and holding back on releasing losses that would otherwise me reducing your total capital gain and thus your tax charges for the year. What will often happen is finally the investor flips after several years and decides to clear out their portfolio of losers in just one year, and by releasing all their losses in one big chunk that far outweighs the gain in that year, again they are wasting the tax benefit of losses.
9. They buy leveraged funds when they really shouldn’t.
Leveraged funds are appearing left right and centre at the moment. Leveraged funds can be bought that multiply the daily movements of various indexes, from a 3 x multiplier of the FTSE100, to a 2x short position in oil (where a £10 loss in oil would give you a £20 gain). Many new investors make the classic mistake in concluding that a double leveraged FTSE100 tracker will deliver double the performance over a given year. On the assumption that stocks have a positive return, this would lead the new investor into believing they have discovered a strategy that will double their long term profits. They couldn’t be more wrong!
Leveraged funds are not suitable as medium or long term investments, and should not be used for positions held for longer than a day.
The problem lies in how these funds work. They take the daily change in the index or benchmark, then double it. This is different to holding an index which will, over the long term, produce returns double that of its original.
The only way to explain this is for you to see the problem in action through an example:
Imagine you invest £100 in an index that tracks the FTSE100 (investment A), and another £100 in a leveraged index fund that doubles the daily change in the FTSE100 index (Investment B). On the 1st day, there is a 10% rise in the FTSE100. This puts investment A at £110 and investment B at £120. So far so good. On the next day there is a large loss of 20% on the FTSE100. Investment A will fall to £88, and investment B will fall to £72. Finally on the 3rd day, the FTSE recovers by 15%. The final value of investment A will be very close to the beginning at £101, a small profit. Investment B however would be worth £94 – a loss!
It simply doesn’t work. This really is a mathematical problem, but I don’t need to explain the theory to prove my point. Mistaken investors have already experienced the horror when the underlying index drops, or recovers to its original value that they originally bought in at, only to realise that the value of their leveraged investment has made a heavy loss. They certainly won’t be touching leveraged funds again, and neither should you, unless you want to make a one-day bet on an index.
10. They trade too frequently.
Trading fees for retail investors are pretty high, with the prices ranging between £17 for infrequent investors and £6 for frequent traders. The problem is that new investors confuse ‘frequent traders’ with ‘day traders’, and believe that they can profitably day trade with £6 trading commissions to buy and sell. In other words, a day trader has to make £12 per trade just to break even. Achieving this on a reasonably-funded account is extremely unlikely. With a £50,000 account, you would never want to be committing more than £500 per trade, at which price point, the trading fee would be 2.5% of your trade amount. If, with a modest financial education, you believe that you can consistently generate returns in excess of 2.5% on trades that are closed within a matter of days, you must have been blessed by the gods!
If you want to actually become a day trader, you will need to invest £X,000s in trading software and charting tools that will allow you to trade like a pro, and execute at very low prices. Such investment puts off many from the day-trader lifestyle.
I hope that this article has changed your mind on perhaps a few misconceptions you previously had about investing. If you’re a seasoned investor and you recognise a few mistakes above that you made yourself when you were beginning, share your experiences below! Leave a comment to tell me what you think about these mistakes.