Rick Salmeron, an adviser in Texas, wrote a short article about common investor mistakes for Dow Jones Adviser. It’s written, of course, from the investment adviser’s viewpoint, and sums up years of experience working with clients and seeing what people do right, and wrong, when making investment decisions.
Here’s Rick’s opening comment:
“When I first got into the financial-service industry, I thought my job was to find the best investments for my clients. I realized five years ago that you can find the best investments on planet Earth, but they don’t do your clients any good if poor behavior dictates their investing strategy.”
Wow. Isn’t that the truth. Rick then goes on to identify four main investor mistakes: panic, overconfidence, under-diversification, and letting cost basis dictate your investment decisions.
He’s right on track about all four.
Remember 2008? That was panic at work. Investors sold investments at ridiculously low prices because they were afraid the market would never stop going down. Panic means letting short-term fears override long-term strategy, and incorrectly assuming that when things are going down, they’ll go down forever. It makes a mess out of your asset allocation and locks in losses by selling at the lows. The lesson: stick with your allocation; it provides you with the discipline to ride out shorter-term dislocations.
Overconfidence? Investors guilty of this jump on the “hot” investments and want to load up when the price is skyrocketing. They always want to move money to the hot new thing (think China, gold, undiscovered tech company, etc.), which plays havoc with the portfolio allocation and kicks diversification in the teeth. Those same investors who jettisoned stocks on the way down (e.g. they didn’t want to own many, or any, when they were cheap) are chomping at the bit to buy back now that the tide has turned. Same stocks, same investor, same goals. Except now, the stocks are twice as expensive. Go figure. The lesson: nothing goes up (or down) forever. Always ask yourself what can go wrong, and avoid betting the farm unless you don’t mind losing it.
Clients guilty of under-diversification sound very reasonable. All they want to do is get rid of what “isn’t working” and get more of what “is working.” Sounds fine, right? Unfortunately, in practice, this compounds the errors already committed in the name of panic and overconfidence. If it’s going down or didn’t do well, sell it. If it’s going up, buy it. Notice a pattern here? Selling low and buying high is exactly the opposite of what you’re supposed to do as an investor. Diversification means that not all investments move in lockstep. Some go up, some go down. It may sound like a no-brainer to eliminate the ones that “aren’t doing well” but take my word for it, you will regret it. Big time. That’s what got so many investors into trouble in 1999 with the tech bubble. They sold all their investments that weren’t performing up to snuff – bonds, value stocks, REITs – and piled onto the tech bandwagon. Looking back, not the best of moves. It happened again when investors overloaded with real estate, which seemed like a “can’t miss” opportunity. The lesson: diversify, not just because it’s good investment practice, but because it protects you from … you.
Letting cost basis dictate investment decisions is a pretty common mistake. Even professional advisers can misuse and be misled by cost basis information. Without getting bogged down in the details (let’s save that for another blog), tell yourself that cost basis is only good for one thing, and that’s calculating your gains and losses for the IRS after the sale. It has virtually nothing to do with investment performance or analysis (just take my word on it for now). If you use cost basis to make investment decisions, you are making a big mistake. Think of it like using your car’s rear view mirror to navigate as you drive down I-95. The mirror works great, but unfortunately, it only shows where you’ve been, not where you’re going.
I can’t begin to tell you how many million dollar fortunes I’ve seen go down the tubes because people were looking back, not forward. Investors often resist selling because they don’t want to take gains, or procrastinate cutting back because the stock is still doing “so well.” Ask anyone who had large holdings of tech stocks in 1999, or financial stocks or bonds in 2008. From Friday evening to Monday morning, fortunes were undone. The lesson: make investment decisions based on investment criteria, not the potential tax bill.