They say that experience is the best teacher. However, when money is at stake, it is wise to learn from the mistakes of others rather than your own! Don’t you agree? This is why I’ve assembled my list of the top ten common mistakes made by new investors.
1. They don’t apply the science of diversification
‘Don’t put all your eggs in one basket’ is a well-known maxim, and one that is rigorously practised by finance professionals, whether they’re pension fund managers, mutual fund managers or even day-traders.
New investors interpret this as an instruction to invest in over 20 stocks and shares to tick that box. This is unhelpful. The science of diversification is more complex than this.
Some new investors get it half right; they appreciate that they should invest in as many different industries as possible to lower the impact of a single industrial event (such as a plane crash) on their whole portfolio. They look into Japanese bonds and Canadian mutual funds.
Some investors go even further and invest in companies of different sizes. This will help negate the effects of regulations and disruptive entrants to industries.
The investors who do more research will know that a wide geographical spread of investments will further help to balance their portfolio and mitigate out events that affect certain regions such as emerging markets.
However, even these investors are missing an opportunity to further diversify. They’re missing out on alternative asset classes.
These are entirely different types of investments. They include:
- Peer to Peer lending platforms
- Investing in property
- Investing commodities
- Art, fine wine & other collectables
All of these have positive expected returns which fall in a different pattern to the stock market. This lack of synchronisation will help smooth out the ups and downs in the stock market and produce a more consistent return over time.
Alternative asset classes need only make up a small part of your basic investment portfolio to have a positive effect.
2. They expect active mutual funds to outperform
Here’s a shocking truth:
As a group, mutual funds do not provide higher returns than the stock market average, after fees.
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On this basis, studies have shown that 75% of mutual funds actually underperform the benchmark index that they’re supposed to beat. How disappointing.
Why is this? Are they making poor investment decisions? Not quite – it’s all in the maths.
Asset managers cannot escape the fact that they control over half the money invested in the stock market. 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 market participants can ever achieve a higher-than-average result. After taking their fees into account, many of the managers who have only marginally beaten the market, also fail to beat it.
This leaves a relatively small percentage of funds that can even possibly add value.
And to think that investors chose active mutual funds in the first place because they wanted to avoid making difficult choices. But with these bleak odds, investors are left making the most difficult one of all – picking a winning fund from an industry of losers!
In contrast, one can invest directly in a market index’s constituents (such as the whole of the FTSE 100) through a cheap and passive index fund, which aims to match the market return. With wafer-thin fees, investors can expect to match the market every time, beating the majority of ‘expert’ asset managers in the process!
3. They view commodities as a ‘safe’ investment
Gold is revered in the financial media as a ‘safe haven‘ for investors. But are commodities a safe investment?
Safe haven, versus safe investment. Inexperienced investors don’t see much difference between those two terms, but that’s the essence of this mistake.
A ‘safe haven’ protects the investor against the adverse effects of a risk, but that risk isn’t necessarily the risk of loss.
Gold, for example, is generally seen as a protection from inflation risk.
In the current economic environment, where inflation rates have rarely topped 2% over a full decade, this doesn’t feel like a particularly valuable characteristic.
So, investors may find themselves in a gold investment or another commodity from our list, without any real protection against the largest risk of all – capital loss.
Gold is susceptible to violent market volatility just like any other commodity. While gold (as of writing) currently stands at a relatively high price 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, and I don’t feel that commodities are suitable for beginner investors.
4. They avoid using Independent Financial Advisors (IFAs)
Independent financial advisors charge sizable amounts to provide advice or even manage your portfolio.
This is in contrast to restricted advisors in banks or insurance companies who sell the financial products of their employer. Their costs are usually included somewhere in the small print, and you may only realise this when you sign-up to the product.
Restricted advisors cannot compare the whole of the market, and therefore cannot make the best investment choice for you. However, new investors often find themselves in their offices because they are usually linked to a product or service that they already enjoy.
Make the intelligent decision to engage a fully independent advisor, who only has an incentive to provide good advice!
5. They then seek advice from the wrong places
After avoiding the financial advisors that will work in their best interest, many new investors will take some advice from sources that they really should ignore.
a) 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 stock market has plenty of upside, and the next day they could be outlining why it is over-valued. Pundits are paid for their ability to hold people’s attention rather than for the accuracy of their forecasts.
Don’t let your investment strategy be determined by the ‘lottery’ of which interview you happened to watch, or which article caught your eye in a financial newspaper column.
It’s useful to use the media to research company share prices or commodities news online. But it’s healthier to use these websites to retrieve facts and data rather than depend on them for ‘guidance.’
b) ‘Penny’ stocks or shares advertised online or in unsolicited mail
Penny stocks are the listed shares of tiny companies (or large businesses that have seen their value fall to zero). These are often promoted by online investment scammers who will sell their own holdings after the share price receives a nice boost from victims purchasing shares in the company.
I cover these in more detail in my article How not to pick stocks and shares.
6. They expect structured products to deliver stock market returns with no risk
Structured products work in complicated ways but sound quite simple.
They might promise a fixed return of 7% if the stock market rises over a certain period. The apparent advantage over a traditional investment is that your capital might be partially protected if the stock market falls.
It’s a unique proposition and many investors view structured products as sitting in a comfortable ‘middle ground’ between safety and the stock market.
The downsides of structured products are numerous:
- The probability of the stock market rising over a given period will be unknown, so investors are susceptible to overestimating those odds.
- Investors in structured products miss out on dividend income.
- This means that risks can be higher than normal investments as there is no dividend income to act as a buffer against capital losses.
- You are reliant upon the investment provider remaining solvent.
- The fees are hidden and unknown (and therefore are likely to be high).
7. They let the wrong factors guide their investments
As humans, our soft and squidgy emotions direct our thoughts. In the world of investing, this is something that should be resisted.
If we let our decision making become emotional, we could make the following mistakes:
a) Sell shares after bad news. If the news is already public, then the price 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) Hold too much cash. Sometimes the fear of missing a future opportunity causes people to hold far too much of their assets in cash. If it was invested in a simple portfolio, that cash could be working much harder.
c) Buy 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 foolish.
d) Buying on the recommendations of our friends. It may be tempting to be swayed by the decisions (and even success) of our friends. We experience a natural urge to follow the herd.
You may have to fight against this instinct in order to protect your carefully-crafted portfolio from becoming studded with random ‘hot picks’.
8. They hold onto losers and sell winners
Why investors 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. Quite the opposite – the courage to hold on.
How many times have you wondered about a dream scenario of investing into an IPO of a small company when shares are worth £1, and seeing those share rise to £500 per share after a whirlwind period of growth?
If not about shares, perhaps you’ve wondered at some point; ‘what if I had invested in Bitcoin?‘.
In those daydreams – did you ever reflect on how unlikely it is that you would still hold onto those shares once they had doubled in value?
Hindsight is a wonderful thing, but you are completely blind in the middle of any investment story. A two-fold return might be the first step towards a 100-fold return, but it’s more likely that it’s the highest the price will ever get.
Our aversion to loss means that we feel an overwhelming desire to bank a win. Once we sell, we can chalk up the trade as a success in the safety of knowing that we are no longer exposed to a reversal in fortunes.
Why investors hold onto losers
On the other hand, you see investors who cannot bring themselves to sell out of loss-making positions. They keep these ‘dead cows’ in their portfolio for several years in the hope that things will pick up again.
This is loss aversion striking again. Because a loss has already been incurred – there’s no apparent downside to holding onto the share – a loss is a loss. There’s also upside in the hope that the loss reverses.
But is that the right way to think about it?
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 I was given the opportunity?’.
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 unfortunate side effect of selling winners and holding onto losers is that this increases, rather than avoids tax when investing.
This strategy maximises capital gains tax, because you’re incurring gains as soon as possible, and holding back on releasing losses that would otherwise reduce your total capital gain.
What will often happen is finally the investor decides they’ve had enough after several years and decides to clear all of their losers from their portfolio in one go. By releasing all their losses in one tax year, they may waste the tax benefit of those losses.
I explore this topic further in When is the right time to sell stocks and shares?
9. They buy leveraged funds
Leveraged funds are a recent phenomenon. They provide an amplified return of an index. An example is a fund that provides triple the daily return of the FTSE 100.
Many new investors make the mistake of assuming that a double leveraged FTSE 100 tracker will deliver double the performance of the FTSE 100 over a given year.
They couldn’t be more wrong!
Doubling the daily return of an index will not produce twice its annual return further down the line. Volatility is toxic to returns – as large losses have an outsized effect compared to large gains.
If the FTSE 100 falls by 45% on day one and rises by 70% on day two, it will end the second day at 93% of its original value.
If a 2x leveraged fund doubled these returns to -90% and +140%, it would end the second day at 24% of its original value. You can do the maths yourself to check this out.
This is an extreme example but it demonstrates the mathematical phenomenon which will eat away at the value of a 2x or 3x leveraged fund.
10. They trade too frequently.
Trading fees for retail investors are pretty high. Prices range from £6 for frequent traders to £17 for infrequent investors.
When investors trade frequently, these investment costs become losses. And those begin to pile up at speed if an investor chooses to jump in and out of positions like a pro.
With trading and other fees working against an investor, profits need to be higher still to offset them.
With a £50,000 account, you wouldn’t want to commit more than £500 per trade, at which price point, trading fees could eat up to 2.5% of your trade value!
If, with 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 or weeks, you must have been blessed by the gods!
I hope that this article has given you some food for thought before you begin investing.
If you are a seasoned investor and you recognise a few mistakes above that you made yourself when you were beginning, I’d love to hear from you!
Please leave a comment to tell me what you think about these mistakes.