You're Doing It Wrong: 4 Mistakes That Make Everyone a Bad Investor

"How can I become a great investor?"

That's probably the most common question we get from Motley Fool readers. 

But for most investors, especially beginners, it's the wrong question to ask. Most investors underperform the market. When that's the case, how to become a great investor isn't what's important; becoming a less-bad investor should be the goal. The difference is subtle, but important. Economist Erik Falkenstein explains:

In expert tennis, 80% of the points are won, while in amateur tennis, 80% are lost. The same is true for wrestling, chess, and investing: Beginners should focus on avoiding mistakes, experts on making great moves.

Accepting this should change the way new investors think about investing, from trying to find the next big winner to trying to avoid the next big blunder.

Here are four big blunders investors commonly make.

1. You lack diversification
There's a scene in the documentary "Enron: The Smartest Guy in the Room" where Enron's HR director is asked by an employee in a 1999 meeting, "Should we invest all of our 401(k) in Enron stock?"

The HR executive laughs and blurts out, "Absolutely!"

Enron stock made up more than half of Enron employees' 401(K)s when the company went bankrupt a year later, according to FINRA.

Warren Buffett once said, "Diversification is protection against ignorance. It makes little sense if you know what you are doing." But most investors don't know what they're doing, and Buffett's own Berkshire Hathaway (NYSE: BRK-B  ) controls 55 separate subsidiaries in industries ranging from underpants to private jets, newspapers to industrial chemicals.

William Goetzmann of Yale and Alok Kumar of the University of Texas analyzed the portfolios of 60,000 investors over a six-year period and concluded: "The least diversified (lowest decile) group of investors earns 2.40% lower return annually than the most diversified group (highest decile) of investors on a risk-adjusted basis."

From Enron to General Motors to Kodak and Lehman Brothers, the number of companies that have gone from revered blue chips to bankrupt casualties is longer than you might think. And every stock and every asset class will eventually experience a drawn-out period of dismal underperformance. History knows no exception to this rule, but it knows many investors who learned it the hard way.

2. You trade too much
The decline of trading costs is one of the worst things to happen to investors, as it made frequent trading possible. High transaction costs used to cause people to think hard before they acted.

Terrance Odean and Brad Barber of U.C. Berkeley studied tens of thousands of individual investors and came to an important and pith conclusion: "Trading is Hazardous to Your Wealth." 

Investors who traded the most underperformed the S&P 500 (SNPINDEX: ^GSPC  ) by more than six percentage points per year, the pair found. That's a staggering amount. Over time, it's the difference between a good retirement and no retirement.

Inexperienced investors tend to overestimate their skill, convincing themselves they can beat the market by actively trading when, in fact, they stand little chance. "Overconfidence can explain high trading levels and the resulting poor performance of individual investors," Odean and Barber wrote.

There's some good news. Last year, three economists published a paper showing that investors tend to earn better returns as their experience increases, and a characteristic of experienced investors is lower portfolio turnover. Experienced investors learn from their mistakes. If you're new to the game, try to learn from them vicariously.

3. You plan for the long run and react to the short run
Most investors have a plan, whether it's subconscious or explicit: They're trying to have more money to finance some event down the road, like retirement or school for their kids. That "event" is usually years or even decades away.

But while we plan for the long run, most investors react to the short run.

Retiring in 10 years? You lose sleep when the market has a bad month.

Kids going to college in 15 years? Stocks have a bad day, and you question how you've invested their college funds.

It's natural to do this. I do it, too. But while long-term financial plans have the benefit of compound growth, short-term reactions have the curse of emotions and randomness. Very few decisions investors make based on reactions to short-term market moves will help them achieve their long-term goals. The investor who ignores the noise and becomes blissfully unaware of what the market did last week may have a big advantage over the professional who watches every tick.

4. You ask the wrong questions
The investment media provides answers. Here's what stocks you should buy. Here's when you should sell. Here's what this news means for you. Do this. Do that.

But even when these answers come from smart people (they often don't), they can be addressing the wrong questions.

Instead of asking what stocks you should by, many investors should ask whether they should be picking stocks in the first place (passive index funds are a great alternative).

Instead of asking what the market did today, many investors should ask whether it matters at all if they're in it for the long run.

Instead of asking how much potential an investment has to increase, many investors should ask whether they can afford to take additional risks.

Financial advisor Carl Richards has a smart three-step plan investors should ask themselves before making big decisions:

• If I make this change and I am right, what impact will it have on my life?

• What impact will it have if I'm wrong?

• Have I been wrong before?

The media can't answer these questions because it doesn't know details about you. But they are some of the most important questions investors can ask.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics. 

Interested in learning more about the economy? My new free report, "Everything You Need to Know About the National Debt," walks you through with step-by-step explanations about how the government spends your money, where it gets tax revenue from, the future of spending, and what a $16 trillion debt means for our future. Click here to read it. 


Read/Post Comments (15) | Recommend This Article (113)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 10, 2013, at 9:53 AM, TMFTheDude wrote:

    Great article as usual Morgan.

  • Report this Comment On July 10, 2013, at 11:20 AM, Seanickson wrote:

    diversification is important but I don't think the study you linked proves much of anything.

    First of all, I think the concept of risk-adjusted is misguided as I think beta differs greatly from actual risk. Secondly, the 6 year period that was measured 1991-1996 was an extremely positive ones for stocks and insufficient to draw a conclusion about how less diversified investors would do in a different market environment.

  • Report this Comment On July 11, 2013, at 6:43 AM, daveandrae wrote:

    Truth be told, the dumbest person in the world dollar cost averaging into a two star mutual fund over a thirty year time horizon will still become wealthy.

    Thus, the decision to HOLD equities over all other asset classes accounts for well over 90% of Investor return. Notice I said investor, not "investment." Most people try to correlate these two variables when in fact stock selection and "marked timing", account for less than 10% of one's lifetime return, tops.

    Unfortunately, after more than fifteen volatile years of experience in this business, I have personally seen the overwhelming majority behave in direct opposition to this investment axiom. Damn near everyone I have ever known that has invested in the equity business has spent far more time analyzing the "market" instead of analyzing themselves.

    Thus, you could say, and it would be true, that when it comes to investing, most people get exactly what they deserve.

    “Good thoughts and actions can never produce bad results; bad thoughts and actions can never produce good results. We understand this law in the natural world, and work with it; but few understand it in the mental and moral world—although its operation there is just as simple and undeviating—James Allen, As A Man Thinketh

    good day.

  • Report this Comment On July 12, 2013, at 11:17 AM, StockGamingCom wrote:

    "Warren Buffett once said, "Diversification is protection against ignorance. It makes little sense if you know what you are doing.""

    According to a BBC documentary on Warren Buffet, he did not diversify in the first few years. But now with dozens of companies that he owns, he is very diversified.

    One of the biggest mistakes for most investors is letting emotions influence trading decisions, which is impossible for many humans to prevent.

  • Report this Comment On July 13, 2013, at 10:28 AM, SherifX wrote:

    This article refreshes a pressing question: if 95% of individual investors and a similar majority of mutual funds fail to beat S&P 500, why don’t we simply invest in S&P and beat 95% of other investors.

    Putting all of your money, and I mean ALL of it in SPY, the ETF of S&P 500 index guarantees a spot among the most successful investors and fund managers. Precisely the top 5%.. Sounds good to me

    No need to talk about diversification, because the very structure of SPY is diversified, it reflects 500 major companies in the US and parts of the world. It’s an assortment that lets you taste the successes, and the failures, of almost every industry in the world.

    Want to be even more diversified? Try RUT, the Russell 2000 ETF. I noticed it behaves almost identical to SPY but with a wider variety of stocks.

  • Report this Comment On July 13, 2013, at 12:47 PM, rhealth wrote:

    For Warren Buffett and really anyone who ends up too rich, I believe diversification was a function of being overwhelmed and saying enough is enough. Market timing takes a lot of work and research, if you dont have to do it why bother? If i had his money cushion I would just stick it in 3 nations index funds and call it a day. So which is better? Poor and engaged, or rich and lazy?

  • Report this Comment On July 13, 2013, at 1:26 PM, AnsgarJohn wrote:

    Read Superinvestors by Buffett and the 'smart beta' article at Economist.com

  • Report this Comment On July 13, 2013, at 4:54 PM, Zakgirl wrote:

    Excellent article Mr. Housel. I do take into consideration Seanickson's comment on diversification though. And, I don't believe you can ever be too rich, Rhealth, there's always something good you can do with extra cash.

  • Report this Comment On July 16, 2013, at 6:44 AM, Sotograndeman wrote:

    Morgan,

    To quote Enron as an example of why we should diversify is ridiculous. Likewise, Berkshire consists of a large number of companies, not for diversification's sake, but because they are terrific companies which Buffett could buy.

    The place where investors, including most professionals as well as investing sites like TMF, fail is in not having the capacity to truly evaluate companies - which encompasses not only financial criteria but the business itself including management.

    If we cannot get a good handle on the business and valuation, then we cannot begin and if we do, we'll be without a compass when the going gets rough.

    It's a big challenge, and most people have neither the training nor the time to do it thoroughly, and as a result, Buffett has advised the average investor to choose a low-cost index like Vanguard and thereby beat most professionals.

    TMF purports to follow Buffett-like principles and practices, but - forgive me for saying so - it continues to increasingly spout the most superficial and useless articles which try to rationalize, for example, short term stock price movements of companies like BAC or CHK and many others.

    Anyone can talk the talk. It's merely parroting Buffett. But few, very very few, can walk the walk.

  • Report this Comment On July 16, 2013, at 8:14 AM, mikecart1 wrote:

    The term of diversification is misused, mistaught, and misfollowed. As someone that is now well off from investments, looking back, diversification did nothing but lower my overall returns. There is a point where diversification turns into a self-made mutual fund. That point is usually hit by over 90% of investors.

    In a world where everyone looks up to Warren Buffet as some hero or genius, people fail to realize what he thinks about diversification.

    :o]

  • Report this Comment On July 19, 2013, at 7:51 AM, jaelitouz wrote:

    I really hope someone reads this. The truth about this article is that sometimes we don't have patience. I'm under 23 years old and I started investing by my own, no previous experience, didn't even read a lot about it. Just went by heart and by what I thought it was right. Truth is that I acquired a couple of stocks last year at $13, $22, $30. Not a lof of them. Maybe about 12 total. But the reality in all this is that I sold them way too early. Just earned in one of the stocks about $20 each (VMED, which LBTYA bought). I sold the other stocks and loss some money. I was looking at the $13 and $30 stocks, and today they're $40 and $76 respectively. All I didn't have was patience and enough money to invest. Now that I have saved some money, at least I'm planning to turn that into more. I have the feeling that I have always had the succesful investor mindset in me.

  • Report this Comment On July 27, 2013, at 3:16 AM, repeal209 wrote:

    frequent trading can be way more profitable if done right, but it also requires much more from the trader (strong heart, intuition, reaction, analytical skills, math skills, psychology and so on)

  • Report this Comment On August 01, 2013, at 6:40 PM, lutherwilliam wrote:

    The list of "mistakes" is right on the money, with frequent trading being my Achilles' Heel. In the early '80s discount stock commissions were $55, so you thought about it hard and traded less. Now I rationalize that if the amount of the trade comprises $250, my trading costs are a mere $10 (5% of the trade) and that I'm within sensible limits. The result: even though my picks have all gone up, along with my periodic accumulations of $250 (+ $10), my portfolio shows that my top 10 investments are all non-commission funds (ETFs and mutuals) from my broker rather than the hi-flying stocks (like Celgene) that I started purchasing up to a year ago.

    The funds are variations on index funds with no transaction costs and low fee ratios. I've learned that frequent purchases of many stocks is not a sound investment system--it's an expensive hobby. But I enjoy it, and as long as I don't check my actual profits very often, I'll probably continue to buy stocks $250 at a time. (When trades were $50, it would have seemed insane to pay a commission representing 25% of the value of a trade.)

  • Report this Comment On August 01, 2013, at 6:43 PM, lutherwilliam wrote:

    I'd like to see recommendations about the minimal amount to invest per trade in order to reduce if not eliminate the damage done by $10 commissions.

  • Report this Comment On August 01, 2013, at 10:52 PM, daveandrae wrote:

    Over the last twelve months, the s&p 500 has appreciated by more than 28%. And this return ignores dividends.

    Meanwhile, over the same time period, cash yielded next to nothing.

    Thus, using both logic and arithmetic, it was impossible to "beat" the market over the last twelve months using a system that traded currency back and forth between an asset class that yielded 28% (stocks) and an asset class that yielded 0% (cash.)...And I am ignoring commissions, fees and capital gains taxes.

    Put simply, even if trading were completely TAX FREE it would have still been a waste of time and money compared to simply buying and holding the market. For when one juxtaposes the difference between investment performance and investor return, he will see that the overall results are horrifying.

    And please, don't take my word for it. For the one and six month trading data for individual investors is listed each Wednesday in the money section of USA today newspaper.

    good day

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