"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:^SPX) 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.