A recent study by DALBAR, an independent research firm, concluded the average stock investor had received a 3.83% annualized return from 1991-2010, while the S&P 500 generated a 9.14% annual return over the same period. The study concluded that investor behavior tends to cause investors to underachieve the market. Below is what I would consider the top eight mistakes the average investor makes.
Mistake 1: Excessive Buying and Selling
A study of more than 66,000 households found that investors who traded most frequently underperformed those who traded the least. For the study, investors were split into five groups based on their trading activity. The returns achieved by the 20 percent of investors who traded the most lagged the least active group of investors by 5.5% annually. Another study showed that men trade 45 percent more than women, and consequently, women outperformed men.
Mistake 2: Information Overload
Those who monitor the market too closely have a tendency to undermine their portfolios with self-destructive behavior. Richard Thaler, a professor at the University of Chicago, conducted a 25-year study where he divided investors into three groups: one group who checked their investment performance every month, one that checked performance once per year, and one that checked performance every five years. The study concluded that individuals who check performance the most obtain the lowest investment return and are most likely to sell an investment immediately after a loss. Of course, selling low is not a good strategy for making money.
Mistake 3: Market Timing
History has shown that the market rises about 70 percent of the time. Market timers tend to find themselves out of the market during the 70 percent of the time it’s going up because they are trying to avoid the 30 percent of the time the market is falling.
Market timing is typically driven by emotion. Investors tend to buy stocks when they feel good and sell when they feel bad. Unfortunately, investors tend to feel good once the market has run up 20 percent and feel bad when their portfolio is down 20 percent. With the “feel good/bad” strategy, investors will always buy after the market has already gone up and sell when the market has already fallen.
Mistake 4: Chasing Returns
Guess which mutual funds attract the most new money each year? Money flows into mutual funds that have just enjoyed the greatest performance in the previous year. Unfortunately, investors are often late to the party with this strategy. For instance, in 1999 the Nicholas-Applegate Global Tech I fund posted an unbelievable 494 percent return, and investors saw instant riches parading before their eyes. Yet, an individual investing in this fund at the start of 2000 experienced the following returns: -36.37% in 2000, -49.26% in 2001, and -44.96% in 2002.
It shouldn’t be surprising that chasing returns is a very common mistake. The entire financial media industry is built around a common theme: “Don’t Miss Out on the Ten Hottest Stocks.” When the fine print says “past investment performance is no guarantee of future returns,” believe it!
Mistake 5: Poor Diversification
You may have seen this mistake coming. Investors tend to be concentrated in one or two companies or sectors of the market. Over-concentration can hurt a portfolio, whether the market is performing well or poorly. Poor diversification leads to excessive volatility, and excessive volatility causes investors to make hasty, poor decisions.
Mistake 6: Lack of Patience
Most mutual fund investors hold their funds for only two or three years before impatience gets the best of them. Individual stock investors are even less patient, turning over about 70 percent of their portfolios each year. It’s difficult to realize good returns from the stock market if you invest for only weeks, months, or even a couple of years. When investing in stocks or stock funds, investors must learn to set their investment sights on five and ten-year periods.
Mistake 7: Not Understanding the Downside
When you buy an investment, you should plan on worst-case scenarios occurring when you invest. It is true that past performance isn’t guaranteed to repeat, but it does give us an indication of what to expect on the downside. Know how your investments performed during recessions, wars, terrorist attacks, and elections. If you don’t understand the risks at the outset, you are more likely to react poorly during periodic market setbacks and get scared out of the market.
Mistake 8: Focusing on Individual Investment Performance Rather than Your Portfolio as a Whole
Ray Levitre, author of The 20 Retirement Decisions You Need To Make Right Now, said “One way to know you are diversified is that you will always dislike a portion of your portfolio.” If you are properly diversified, I can guarantee you that each year some of your investments will lag behind others in your portfolio. If you look at investments in isolation rather in context of your overall portfolio, you will be tempted to make poor decisions. You can get yourself into trouble by getting rid of investments when they’re low in value and replacing them with those that just experienced a nice run.
Most of these mistakes can be avoided by having a clearly defined, long term investment strategy. Before investing, develop a proper diversification strategy, a system for evaluating the performance of investments, and solidify your long term investment goals. Then, turn off CNBC and refer back to the systems and principles of your strategy when it is time to make investment decisions.