Pitfalls

   By Guest Blogger Ryan Lewenza

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To be financially successful and build up a big investment portfolio requires doing many things right (starting early, doing research and remaining disciplined) and avoiding the mistakes and pitfalls that investors often fall into.

Case in point. Jesse Livermore was one of the greatest traders to ever live yet few people know of him. He started trading stocks as a young boy at the age of 14 in the early 1900s and made millions over his career. He correctly shorted the market in 1929, just before the great crash, with his net worth hitting a peak of over $100 million (worth $1.5 billion in today’s dollars). But, over his rocky career he made and lost fortunes, ultimately losing it all in the end and taking his own life in 1940.

In today’s blog I’m going to discuss some of the common investor pitfalls, so we don’t end up like poor Mr. Livermore.

First, excessive trading is almost surely going to weigh on one’s overall performance and portfolio values. Numerous academic studies have shown that more active traders, on average, perform worse than more disciplined, long-term investors.

One study showed that very active traders underperform the broader market (i.e., S&P 500) by 6.5% annually. Another study of 10,000 accounts at a US discount broker found stocks that were purchased by clients underperformed the stocks sold by the same clients by 5% in the first year and 8.6% over two years. Essentially, the more active traders are the worse their performance.

Inexperience, high trading commissions and behavioural biases are reasons for this underperformance. Many investors suffer from overconfidence, which is the tendency for people to be more confident in their abilities, whether it be driving, gambling or investing.

Second, investors who try to time the market are usually disappointed and underperform buy-and-hold investors. Time in the market is more important than timing the market. Below is a great chart that supports this. It shows the difference in returns for investors who remained fully invested in the S&P 500 versus investors who timed the market, missing out on the best days over the 30-year period.

If you missed the 10 best trading days, the portfolio would be 54% lower than if you remained fully invested. If you missed the best 30 days the portfolio would be 83% lower. So, stay invested for the long-term!

Impact of missing the best trading days

Source: Ned Davis Research, Morningstar

Third, investors err by not being diversified and too concentrated in a few holdings. This is the classic ‘don’t have all your eggs in one basket’. Research shows over 90% of all portfolio managers underperform their benchmark (e.g., S&P 500 or TSX). So, if professional investors can’t consistently do it then why would a novice investor think they can consistently pick the correct stocks?

Instead of concentrating in a few stocks, diversify across different assets, geographies, market capitalization and styles. This is fundamentally why we like ETFs so much. We can combine different ETFs to build a balanced and diversified portfolio. By using broad-based ETFs we can lower portfolio risk, provide more consistent returns, and, if done correctly, provide greater rates of returns. ETFs all the way!

Third, investors focus too much on headlines. There’s always going to be negative headlines – inflation, wars, US debt levels, and politics – that hold back investors. Look at right now. We have two terrible wars going on at the same time and the S&P 500 has returned double digits this year. It’s why Garth, Doug and I try to filter out this noise and focus on what’s really important. This includes economic growth, corporate profits, and central bank policies.

When you distill it down to the key factors that drive the equity markets, you can block out all this market noise that can often get in the way from successful investing.

Fourth, avoid being too risk averse and investing only in low risk GICs or government bonds. We see this a lot, particularly with older clients. We’ve been in a low interest rate environment for years now with low-risk investments providing paltry returns. Sure, interest rates recently got up to 5% and we locked some of these high yields in for our clients, but rates are now headed lower.These low-risk investments are barely keeping up with inflation. So be sure to include some proportion of stocks, which historically have returned 9-10% annually over the long run. You know the drill: 60/40 balanced portfolios are the way to go.

Finally, a common investor pitfall can be what I call, analysis paralysis. Basically, over thinking every investment decision, which causes people to freeze up like a dear in headlights. These investors get caught up in all the ‘what if’s, which holds them back from investing and sticking to the plan.

Benjamin Graham, who was a well-known financial analyst, investor, and author, famously said, “The investor’s chief problem — even his worst enemy — is likely to be himself.”

Over the last 20 years the S&P 500 and TSX have returned annually 10.4% and 8.3%, respectively. Every day wasted and not sticking to the plan is getting you further behind. We’ve written extensively on the power of compounding, which is far more important than whether you waited and happened to get one good entry point. The lesson here is, do the work and analysis, but then get cracking and execute on the plan.

As I said at the outset, to be successful requires doing a lot of right things and avoiding the common pitfalls that investors often make. Now you know what the key pitfalls are, so get to work and start building!

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

Source: https://www.greaterfool.ca/2024/10/05/pitfalls/