Couldn't Say It Better Myself: CFA Institute Reveals Investors' Most Common Mistakes
By Ric Edelman
Over the years, I’ve tried to help you avoid mistakes that can prevent you from achieving financial success. Through five books, dozens of issues of this newsletter, hundreds of seminars, and decades’ worth of radio and television interviews and broadcasts, I’ve strived to help you become a better investor. But if you won’t listen to me, try listening to the nation’s Chartered Financial Analysts®.
CFAs are not financial planners. Rather, CFAs make investment buy/sell decisions for institutions, governments, investment banks, mutual funds, and corporations. Once a financial planner determines that you need, say, stocks in your portfolio, the planner will often refer you to a CFA, or to an investment company run by a CFA, to determine which stocks you ought to own.
Want a CFA to go nuts? Tell him or her that you manage your own investments. CFAs know that individual investors make many mistakes when investing on their own, and these errors are common and often repeated. Mistakes lead to losses, or lost opportunities, for many do-it-yourself investors.
The CFA Institute recently asked its members to identify the most common mistakes of typical investors. Read this list carefully -- chances are you’ll see yourself portrayed here:
1. People buy investments without first establishing an investment strategy. From the outset, says the Institute, every investor should adopt an investment strategy to guide future decisions. A well-planned strategy takes into account such important factors as time horizon, risk tolerance, and amounts to be invested.
2. People invest in individual stocks instead of creating a diversified portfolio of securities. Investing in an individual stock is riskier than investing in an already-diversified mutual fund, say CFAs. The CFA Institute says investors should maintain a broadly diversified portfolio incorporating different asset classes and investment styles: “Failing to diversify leaves individuals vulnerable to fluctuations in a particular security or sector.” Also, it warns, don’t confuse mutual fund diversification with portfolio diversification: You may own multiple funds that are actually invested in similar industries and even in the same individual securities.
At the same time, however, the Institute cautions that it is also possible to over-diversify and own too many investment products. The best course of action is to seek a balance between the two which, the Institute’s study says, often can best be done with the advice of a professional advisor.
3. People invest in stocks instead of in companies. Investing, says the Institute, is not gambling and shouldn’t be treated as a hit-or-miss proposition. Investing is assuming a reasonable amount of risk to help finance enterprises believed to have positive long-term growth potential. Investors, for example, should analyze the fundamentals of the company and industry, not day-to-day shifts in stock price. Said one CFA interviewed by the Institute, “Buying a particular stock purely because one likes a company’s product or service is a sure-fire way to lose money.”
4. People buy high. If this is so dumb, why do so many investors do it? The main culprit, says the Institute, is “performance chasing.” Too many people invest in the asset class or asset type that did well in the recent past, assuming that it will continue to do well in the future. But that assumption is “absolutely false.” Lamented one CFA, “The classic buy-high/sell-low investor is someone who has a long-term investment strategy, but doesn’t have the tenacity to stick with it. They throw their strategy out the window in response to short-term movements in the market and invest tactically instead of strategically.”
Others at risk for “buying high” are those who follow investment fads, buying the “hot” stocks of the day. Typically, these investments become fashionable for brief periods, leading many to invest at the height of a cycle or trend -- just in time to ride it downward.
5. People sell low. The flip side of buying high can be just as costly. CFA Institute members note that many investors are reluctant to sell a stock until they recoup their losses, because their ego refuses to acknowledge mistakes. By contrast, smart investors are willing to cut their losses when it is time to sell.
6. People churn their investments. Too-frequent trading cuts into investment returns. A study by the University of California at Davis examined the stock portfolios of 64,615 individual investors at a large discount brokerage firm between 1991 and 1996. They found that if investors didn’t have to pay transaction costs, they would have beaten the major stock market indexes. But, after transaction costs were included, investors ended up earning 10% less than the market. Clearly, concluded the Institute, the solution is a long-term buy-and-hold strategy, rather than an active trading approach.
7. People act on “tips” and “sound bites.” Relying on the media is foolish. While breaking news may seem like a promising way to give your portfolio a quick boost, the CFA Institute says you must always remember that you are investing against professionals who have access to teams of research analysts. Believing information that is new to the investor is also new to everyone else is a major mistake. Instead, you should assume that if you’ve heard it, so has everyone else.
8. People pay too much in fees and commissions. Investors are often unable to recite the fees they pay to their investment service provider, says the Institute. Investors should make sure they are fully informed, and all performance data should be adjusted for expenses paid.
9. People engage in decision-making by tax avoidance. While individuals should be aware of the tax implications of their actions, the first objective should always be to make fundamentally sound investment decisions. For example, some investors will let one asset dwarf their other holdings simply because selling it would generate a capital gains tax. Similarly, investors shouldn’t be overly concerned with holding onto a security past the one-year purchase date simply to take advantage of lower capital gains rates.
10. People have unrealistic expectations. As we witnessed during the stock market decline of 2000-2002, investors sometimes exhibit a lack of patience that leads to excessive risk-taking. It is important to take a long-term view of investing and not let external factors cause you to make a sudden change in strategy. By comparing the performance of your portfolio with relevant benchmarks, you can develop realistic expectations. According to Ibbotson Associates, the compound annual return on the S&P 500 Stock Index from 1926-2001 was 10.7%, or 4.7% after adjusting for taxes and inflation. Returns on the Lehman Long-Term Bond Index for the same period were 5.3% and 0.6%, respectively. Says the Institute, “Expecting returns of 20-25% annually will set up an investor for disappointment.”
11. People are neglectful. Individuals often fail to begin an investment program simply because they don’t know how to start. Likewise, people often abandon their long-term strategies after becoming discouraged by investment losses or declines in the stock market.
12. People don’t know their real tolerance for risk. There is no such thing as risk-free investing. In general, says the Institute, individuals planning for long-term goals should be willing to assume more risk in exchange for the possibility of greater rewards, but they shouldn’t wait for a market drop to decide how they feel about risk.
How many of the above describe you? If the answer is more than one, you should be working with a financial advisor instead of trying to invest on your own.