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The Eight Great Investing Mistakes

A few years back, a Dalbar study was conducted to determine the average return of equity mutual funds compared to the performance of the average equity mutual fund investor. From 1984 to 2003, equity mutual funds earned an average compound return of 10.2%. The average investor earned a pathetic 3.5%. Where did the 6.7% go? I have eight good guesses. Below is what I like to call the eight great mistakes of investing. Do any of these look familiar to you:

1.) Over-Diversification: this is where the investor fears missing out on the next big thing. So they hedge their bets and end up with a wide collection of mutual funds. What they fail to recognize is that all of their holdings represent a great deal of overlap and redundancy. The result is a large, expensive, and inefficient index fund.

2.) Under-Diversification: This is where an investor will progressively shed the funds they own, discarding recent under-performers. This ultimately leads to holding funds that are in the same "hot" category over time, usually when the over-performance of the fund is yesterday's news. This is great for talk at the cocktail party, but provides little future reward.

3.) Euphoria, Over-Confidence, or if you split the difference - Greed: This was the poster child of the late 90's. After seeing internet stocks soar through the stratosphere, technology and the internet seemed like the logical choice. Just invest and you become rich! For the ones that actually did pretty well in the beginning, they placed too much weight on their implied skill and less on just being lucky. In the end, only a few of the euphoric investors can sincerely claim they got out at the right time.

4.) Fear: Investors always seem to over-react. Investing hasn't changed much over the years, but outlets like CNBC need to create content on a daily basis and the "crisis du jour" is an ongoing event. The risk averse are more unnerved by this; and the insurance industry profits very well from fear based selling.

5.) Speculation: This is the failure to recognize that your investment strategy is only a legal form of gambling. And the house always has the odds on their side. If your portfolio is a collection of ideas whether self derived or advised and does not involve an asset allocation strategy based on needs, risk tolerance and capacity for risk; you are essentially gambling.

6.) Borrowing to Invest: investing on margin has always seemed to look rational in a hard numbers. But the logic always seems to fly out the door the first day someone ever receives a "margin call". A strategy that is good in theory, but one I have never seen anyone do successfully.

7.) Chasing Yield rather than Total Return: Dividends and interest provide little return after inflation and taxes are factored in. The risk averse can get short-sighted and have the ingrained belief of never drawing on principal. With retirement lasting several decades instead of several years, growth in a portfolio is a necessity, making the concept of the all income portfolio archaic. Seeking total return including capital appreciation is the best defense against inflation over time.

8.) Letting Taxes Dictate Decisions: This one is a two way street. For the investor with large capital gains, they are averse to selling because of the tax implications even though they bear the risk of having an under-diversified portfolio. The focus should be on maximizing after tax returns, not minimizing taxes. The person selling at a loss is more reluctant as it really is an admission of making a mistake, even though it may make sense to cut your losses.

Any of these sound familiar? It seems that the buy and hold strategy is the way to go, but unfortunately many people are a victim of their own bad behavior and there is a price to pay. The average person who invested $1,000 in stock mutual funds in 1984 would have ended up with $1,990 at the end of the period. The average equity mutual fund would have ended up with $6,976; a whopping three and half times more. Looking back, I am sure that there are quite a few investors that wished they had performed in line with the averages.

This was originally written in May of ‘05

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