The seven deadly sins
Want to avoid melting down your investments? Avoid these common errors.
Imagine that it’s 2014, exactly two years since Europe’s great debt crisis passed. The global economy has picked up dramatically. Aid from Germany helped the struggling euro-zone nations get back to their feet. Greece wrote off 50% of its debt, and Portugal, Spain and Italy pushed through far-reaching reforms and tightened their belts.
Deficits have been reduced. Debts are back under control. The western economies are expanding again, and stock exchanges have perked up. The rally that began in mid-2013 overcame the painful losses of 2011 and compensated for the stagnation that followed.
Sound great? There’s a problem. Even if this wonderful scenario pans out, people won’t see the results in their investment portfolios.
Why? Because investors are investors, and when the unexpected happens, they repeat the mistakes they made during the last crisis. Chances are they’ll miss the rallies that just might come in 2013. There’s no reason to think it will be any other way, since investors’ most common mistakes don’t change.
1. Bad fits
One of the most common mistakes investors make is choosing investments that don’t suit their needs, often because they’ve defined these needs poorly. The most important thing investors need to figure out is when they want to use their money. This decision should guide them in deciding where to put their funds − in bonds or stocks.
This is an absolutely crucial decision, regardless of whether we’re talking about picking specific stocks or investing broadly through instruments such as exchange-traded notes or mutual funds. A general rule is the longer you can wait for your money, the better off you’ll be investing a larger portion in stocks. The longer the investment period, the higher the chances that stocks will give you higher returns than bonds or bank deposits.
Yet if you plan to use the money within the next year or so, don’t put it in stocks, which offer higher average returns but also higher risk − meaning higher volatility. The goal of a short-term investment should be to preserve your money’s value against inflation. That’s much more important than trying to capture an extra percent of profit.
Beyond the issue of timing, investors need to suit their portfolios to their personalities. Some investors can’t handle seeing their assets lose value, even if they’re in for the long term and the trend will likely reverse. These people, the risk averse, shouldn’t be putting their money in volatile assets, if only for their emotional well-being. When do these types invest in stocks? When the markets are at their peak, of course. They give in to the temptation and buy stocks, only to dump them when the market suddenly changes course.
2.Itchy trigger fingers
Many investors tend to check their portfolios daily. That’s no great sin. The problem begins when they act on what they see. Let’s say the market has lost 5% over the week. Does that mean it’s time to sell? Maybe yes and maybe no, but that’s a decision to be made based on economic analysis, not panic.
If you have an itchy trigger finger, you probably shouldn’t be checking your portfolio every day. Once you’ve set your time frame and goals and the money has been invested, you don’t need to do much. Let time and money work for you. Returns aren’t achieved in a single day, or even a single month.
Frequent purchases and sales are the main reason people tend to lose money when investing. Haphazard sales mean investors are more likely to miss rallies, an issue we’ll come back to. Plus, frequent transactions generate fees.
3.Acting on fear
Let’s start at the end. The market dropped, you sold out and it dropped some more. What luck you sold when you did − but if the market were to change direction now, you’ve missed the upside. Many investors know this story well. People tend to buy in periods of euphoria and sell for cheap in periods of panic.
U.S. investment firm Morningside examined American investors’ returns from investing in mutual funds. Based on the money entering and exiting the funds, the firm calculated the investors’ returns. What they found was disturbing: Investors achieved lower returns than the mutual funds did. In the five years starting in 2005, the average annual return of all mutual funds specializing in U.S. shares was 0.91%, while people who invested in these funds achieved average annual returns of only 0.64%. When it came to funds that invested in non-American shares, the gap was even more pronounced: 5.23% versus 3.27%.
While these findings relate explicitly to shares, we can extrapolate regarding pretty much any kind of investment portfolio. Morningstar’s economists note that in periods of business as usual, many investors time the market well and generate excess returns. But during crises, many investors act rashly, not only wiping out these returns, but generating losses.
4.Wowed by the stars
Perrigo’s stock has returned 67% this year, as of December 21. Allot Communications gained 61%, before falling back slightly on late-December reports it sold technology to Iran. Mellanox achieved a market cap of NIS 4.5 billion on its 32% gain this year. All this happened as the blue-chip Tel Aviv-25 Index lost 18% and the broader Tel Aviv-100 Index lost 20%. But does that mean investing in these companies now is a good idea? Not necessarily.
Perrigo, Allot and Mellanox did well in their respective industries this year. They may continue doing well, but their stocks’ big gains show that investors were watching, and there’s a chance their shares are now fully valued. As investors, we want to invest in undervalued stocks. So don’t jump on a share that’s already had its day. Check out the company and consider whether it still has potential to grow; don’t jump to conclusions based on past performance. You’ll make your money based on what the share does in the future.
This is true for mutual funds, too. A joke in the industry goes, “Want to lose money? Buy the best-performing fund of the year.” A recent study published in the U.S. newsletter Hulberg Financial Digest reviewed American analysts’ recommendations between 1990 and 2005. Every year, the researchers picked a top analyst whose recommendations had achieved the highest returns; they then simulated an investment in that portfolio for the following year. That strategy generated returns of almost zero over 15 years.
This proves a basic point: Even the world’s best money managers can’t beat the market − and other managers − every year. First, in some years the market simply defies good analysis, and second because analysts are people too − they err. So when possible, judge mutual funds’ returns over several years, not just one. This raises your chances of success. Choosing a money manager who achieves excess returns over time is good enough, better than choosing the star of the year.
Diversification is the big secret of portfolio management. It raises chances of good returns and minimizes risk. So even if a company suffered some bad business deals and its share price plummeted, that won’t ruin your whole portfolio. The most recent crisis showed that there’s no such thing as a no-risk investment, as even European government bonds plunged in value. That’s what makes diversification so important.
Diversifying based on sectors will ensure that even if a specific industry hits the rocks, it won’t take your entire portfolio with it. Geography is an equally important way to diversify. Israeli investors, even professional money managers, tend to invest mainly in Israel, even though there’s a wide range of excellent options abroad. You can diversify by investing based on different currencies.
For the average investor, who probably has no more than a few thousand or a few ten thousand shekels in play, it’s very difficult to fully diversify while buying individual bonds or stocks. Thus, take advantage of instruments like exchange-traded notes, which achieve maximum diversification by letting you buy into an entire index and the dozens if not hundreds of stocks it includes − and for low management fees to boot. Mutual funds, which exist for a wide range of industries and geographic regions, are also a decent option.
One of the hardest questions facing investors is when to sell a losing stock. By selling, you have to acknowledge that you lost money. But this psychology is dangerous because it encourages investors to stick with bad stocks for the wrong reasons. As Nobel Prize laureates Amos Tversky and Daniel Kahneman said, “A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him.”
The tendency not to sell at a loss is very common, because investors believe that if they keep the stock, it’ll reverse course and compensate them. On the other hand, if they sell and lock in the loss, even if the stock recovers, they won’t enjoy the fruits. Thus many investors just leave the stock in their portfolio, thinking, I didn’t sell, so I didn’t lose.
In practice, they’d be better off finding out why the stock is losing money and trying to predict whether the company is likely to recover. If it’s not, and if the money could be achieving better returns somewhere else, then yes, sell at a loss. One recommendation for investors who have trouble selling at a loss is to sell half the holding. So if the stock ever recovers, they’ll enjoy the fruits, and if it doesn’t they’ve cut their losses.
“I don’t touch the capital market, only real estate,” an acquaintance recently told me. “There I know what I’m buying and what’s happening to it. And I’m always left with the apartment.” Many investors consider real estate more of a sure thing.
Before expressing an opinion on this, ask yourself: Have you ever seen someone buy an apartment based on a friend’s recommendation, or run off to get a mortgage because he’s impressed by price increases? No, not really. People who buy investment apartments check things out thoroughly − what returns will the asset achieve, what the potential increase in value is, who the neighbors are, what the neighborhood’s history is.
Now let’s ask that question regarding stocks: Have you ever seen someone buy a stock based on a friend’s recommendation? Do you know someone who bought a share after its price shot up? Most of us do. During bull markets, people are willing to invest in any passing stock, regardless of whether the company has any revenues whatsoever. Thus, investors who buy based on trends, rumors or recommendations shouldn’t be surprised if they make the wrong choices.
Like an apartment, stocks and bonds merit thorough review before purchase. Read the company’s reports, review its debts, and check out its cash flow and growth potential. Take a look at the company’s sector as a whole. Then look at the price of the stock or bond. Is it trading near its true value? It might be a great company, but its expected growth may already be priced in.
Look at factors such as price-earnings ratios, which may be deceiving since they don’t give the full picture. A company’s P/E ratio may be low and appear attractive, but its shaky financial status may hint that the share is only going to plummet. And remember: Judging based on one factor is like watching a soccer game through binoculars. Following a single player may mean you’re missing the bigger picture.
This article was originally published in the TheMarker Magazine’s December issue in Hebrew.