Common Investor Mistakes

When you first buy a stock or mutual fund, everything looks great. You’ve done your research, everything looks good and you feel like you’ve made progress toward your goals. However, after a few months, things change – performance may not be there, the market and therefore your investment may have been impacted by any number of outside factors, your money manager’s style may be out of favor or maybe the management has changed. There may be any number of reasons why things aren’t working and you may feel like just cashing out.

Now is the time that figuring out whether you should stay the course or make a sale and start somewhere else can make a huge impact on the effectiveness of your investment and ultimately your financial plans. Since, in most cases, our clients delegate this allocation authority to us, we think it’s worth explaining how we go about making such decisions. If we sell quickly or hold on too long and not recognize changes or mistakes, the performance of the portfolio may suffer. If we hold to our principles and apply our long-term philosophy, we’ve found that our portfolios do better. Figuring out the difference between misinterpreting data and letting emotions drive decision making is a large part of successful investing.

The best way to take emotions out of the equation is to have a good plan. When we know the goals that our client is trying to achieve, when we create a plan for constructing and monitoring a diversified portfolio and when we know why we own each holding in the portfolio, then allocation decisions are much easier.

So here are some mistakes we’ve seen other investors and advisors make and what we do to avoid them:

1. Overreacting to lousy returns

Probably the most frequent mistake we see people making on their own is making decisions based on short-term performance. All stocks or mutual funds go through bouts of underperformance for a year or two because there are business cycles, market sector rotation or styles that are out of favor. Some people even sell when their investment outperforms its peers but underperforms the broader market. This approach often leads to selling at bottom and missing a rebound. Short-term performance is noise that you should filter out. If we stay focused on fundamentals--such as costs, management integrity and philosophy, strategy, long-term performance--we usually avoid such mistakes.

2. Trying to predict or ride trends

Another mistake we see is reacting to a macroeconomic trend that’s already priced into the market. Unless you have your own functioning crystal ball, odds are that market prices reflect more information that you can individually synthesize. Yet many people, seeing the latest mass media news, make assumptions that such news isn’t reflected in the market when, in reality, most publicly traded investments are fairly efficient in taking into account such news. There are new products, new information, new technologies, etc. every day but making long-term investment decisions based on “news” without taking into account the broader historical context or the fact that most every other investor hears about the news when you do has ruined many a portfolio.

3. Making decisions on only fragments of the picture

One can make similar mistakes on a micro level, too. Sometimes, investors bail out on a mutual fund because one of its top holdings looks unattractive today. Say you think Exxon is overpriced after energy prices have gone up. You notice it in one of your funds’ portfolios and think maybe we should cut the fund loose. Remember, the portfolio could be eight months old and the fund manager may well have sold based on valuations in the meantime. By monitoring the overall portfolio and the strategy the manager employs, we have a better idea on long-term performance.

4. Waiting to get back to "even"

Have you ever gone to a casino with a friend who won’t leave the blackjack table until he has recouped his losses? It doesn’t make logical sense, yet many people have a hard time cutting their losses and moving on.

The price we paid for an investment only matters when we factor in taxes, which of course, we do in taxable accounts and don’t in retirement or non-taxable accounts. If the holding has lost money, we can get out for free. Yet many people want to wait until they’re back to the dollar amount of their original investment. But why should we hold on if there’s another option in the same category with better prospects? Regardless of what we paid, we want to be in the investment that will deliver best risk-adjusted returns and compliment the rest of our portfolio.

5. Not recognizing fundamental problems

When we become aware of a fundamental problem, we sell. Sometimes people hold on to investments because they either don’t notice a change or because they rationalize staying in by inventing a new case for why it will work. But we’ve found that acknowledging changes and the reality that exists now is crucial to preserving and growing our client’s portfolios. If we bought an investment based on management, we look long and hard at selling if management changes or leaves. If there is turmoil or corruption at a company, we often remember the “cockroach theory” – if you see one, there is probably more. If we made a mistake on valuation or earnings potential, it’s best to let the facts drive our decision making.

6. Failing to rebalance

This is a key mistake that can lead investors to hold positions they shouldn't. It’s always tempting to let winners ride, but that’s how people ended up with two thirds of their portfolio in the tech sector just before the bubble burst or possibly how people are ending up over-weighted in real estate holdings today. Remember that rebalancing means you’re often selling high and buying low. If you rebalanced a well-diversified portfolio at the end of 1999, you’d have sold large growth and technology and bought small value and bonds. Not a bad trade. When we rebalance client portfolios, we’re trimming back on the risks in the portfolio and allowing our long-term strategy to work for us.