INVESTING FOR THE FUTURE

Are you making costly mistakes?

  • 05 May 2020
  • 10 mins
  • Do-it-yourself investors struggle to beat inflation [1]

  • Many choose poorly, trade too often, are overly influenced by the media and repeat their mistakes

  • The good news is that these mistakes can be avoided

Causes of poor performance

According to research by Barber and Odean [2], individuals are generally pretty poor at investing. The major observation is that, while there is a wide variation of performance levels, individual investors overall tend to achieve lower returns than their professional counterparts. This is illustrated in the chart below which shows that average private investors’ returns are way below those of a range of asset classes.

The figures refer to the past and past performance is not a reliable indicator of future results. The value of investments and the income from them can fall as well as rise and is not guaranteed, and you might not get back your initial investment.

So let’s look at some of the major causes for poor performance by individual investors. These are not listed in any particular order.

Too much buying and selling

According to the research by Barber and Odean [2], individual investors tend to chop and change their investments more frequently than their professional counterparts. In fact, they change about 75% of their whole portfolio each year. Put another way, this means their entire portfolio has been changed or “turned over” every 16 months.

The research goes on to show that the more often an individual investor buys and sells stocks, the lower the returns tend to be. Looking at investors’ accounts between 1991 and 1996 the researchers discovered that those who traded the most achieved significantly lower returns than those who traded the least.

The more often an investor buys and sells stocks, the lower the returns tend to be.

Transaction costs reduce profits

Closely linked to the previous point is the costs incurred from trading. Every time an investor buys or sells an asset, they incur a cost. Inevitably, the more trades the higher the trading costs and this reduces profits.

What’s more, the difference between the prices at which investors buy and the sell investments (known as the ‘spread’) acts as a further cost. For example, if you want to buy shares in Widgets Inc. you might pay £1.03, but if you want to sell stocks that you own in Widgets Inc, you might be offered just £0.97.

Therefore, as soon as you buy an investment, not only do you pay a brokerage fee for executing the transaction, you also lose value on the asset that you’ve bought.

Commercial or institutional investors make huge numbers of high-value trades a year across a range of portfolios for large volumes of stocks and bonds. Because of their size, they can negotiate better terms from the dealers. In practical terms this means a narrower spread and lower transaction fees.

So individuals are at a trading disadvantage.

Poor selection

Even allowing for trading too often or paying relatively high trading costs, individual investors tend to be less successful at picking stocks than professionals. According to Barber and Odean [2] individual investors as a group tend to buy stocks that go on to perform poorly. Their institutional counterparts, however, tend to buy stocks that perform better.

Swayed by the media

One of the reasons for this relatively poor selection is the tendency to be swayed by the press. Individual investors tend to buy shares in companies that are in the news more often than they sell them, irrespective of the companies’ prospects. Rather than conducting in-depth research in a stock, individual investors can place too much faith in what the media are saying about a company. This lack of research is called ‘speculative investing’. In the short term, this increased demand for a company’s shares will push the price up but this is soon undermined by the fundamental realities of the company’s future which can send the price of its shares down.

Individual investors can place too much faith in what the media are saying.

Chasing the action

One of the reasons that individuals are swayed by the media is the relative lack of time or resource they can devote to research. This can lead to individual investors giving not enough attention to important information, and devoting too much attention to old or irrelevant information.

In other words, individuals tend to miss the right information and act on the wrong information.

Repeating past behaviour

When investors do get it right, there can be a tendency to repeat past behaviour for the wrong reasons. The research suggests that investors are more likely to repurchase a stock that they previously sold for a profit than one previously sold for a loss.

The correct approach would be to appraise each stock on its merits at any given time, disregarding what success or failure the investor might have experienced with that stock before. As we are frequently reminded, past performance is not a reliable indicator of future results.

This emotional interference is at the root of many mistakes which is why Robbie Burns [3], author of “The Naked Trader” encourages investors to “be like Spock” and leave emotions out of the research and investment process.

Following upward momentum

This emotional weakness also manifests itself in the pursuit of stocks that have already risen in value and are far less likely to buy a stock whose share price has been falling. A rising stock isn’t necessarily a bad thing to invest in provided the research and analysis point to continued gains, although performance is never guaranteed.

Unfortunately, individual investors don’t always do this homework. Barber and Odean [2] believed that individual investors tend to buy stocks because of what they hope will happen and sell stocks because of what has already happened.

This leads to their further conclusion that many investors assume the recent past is indicative of what is to come.

It isn’t.

Selling winners and keeping losers

The research suggests that people are much more likely to sell investments that have risen in value while keeping those that have fallen in value. This has two potential problems.

Firstly, investments that are doing well might have more growth to deliver, while those that are falling might be hung on to for too long. The net result can be to bring the overall value of the portfolio down.

Secondly, when an asset that has grown in value is sold, it can attract capital gains tax, reducing net profits. Selling the losers could offset some of these gains, reducing the potential tax. By selling only the winners, an individual investor might be creating an unnecessary tax bill.

Individuals might be creating an unnecessary tax bill.

Tax treatment depends on the individual circumstances of each client and may be subject to change in the future.

Being male

But not all individual investors are created equal. The research suggests that women are less susceptible to a couple of flaws than men. Overconfidence can explain the relatively high turnover rates and poor performance of individual investors [1]. Analysis of trading patterns indicated that men are more prone to overconfidence, overtrading and poor performance [1] than women

Men are more prone to overconfidence, overtrading and poor performance.

Lack of diversification

The final observation of this list of investor errors, is a lack of diversification: individuals tend to prefer local and familiar stocks. Once again, too much emotion and too little research is driving decision making.

This leaves the individual investor’s overall portfolio vulnerable to a fall in the stock price of a relatively small collection of investments.

The current turbulence in asset prices should provide ample incentive to all investors to appropriately diversify their portfolios (though this will vary according to the investor’s circumstances, goals and appetite for risk).

Avoiding the mistakes

Successful investing might be simple, but it isn’t necessarily easy. However, the mistakes that individual investors most commonly make could largely be avoided if you:

1. Do the research. Examine the assets that you are considering buying or selling and make sure that the research is driving your decisions rather than machismo, emotions or the media.

2. Diversify appropriately. Avoid creating a portfolio that carries too much risk or vulnerability to changes in the fortunes of a narrow range of investments.

3, Be patient. Don’t trade too often. Accept that there will be some short-term turbulence in asset prices.

4. Consider being contrary. If everyone else is buying, it might be time to hold or sell. If everyone else is selling, it might be time to buy. And that brings us back to point number 1.

Simple but not easy

But getting these decisions right is not easy and will depend on individual circumstances. The research alone can be daunting. Knowing when to hold and when to ditch a loser is always open to debate. So rather than taking on the yolk of investing, you could get guidance or advice from a professional. According to the research conducted by “The behaviour of individual investors”, Barber and Odean, University of California, 2013, to which this document repeatedly refers, institutional investors incur lower costs, make better decisions and are less corrupted by emotional distractions.

Important information

Any views expressed are our in-house views as at the time of publishing.

This content may not be used, copied, quoted, circulated or otherwise disclosed (in whole or in part) without our prior written consent.

Sources:

[1] “Guide to the markets”, U.S. version, JP Morgan Asset Management, March 2020 slide 63. https://am.jpmorgan.com/gi/getdoc/1383654213584

[2] “The behaviour of individual investors”, Barber and Odean, University of California, 2013.

[3] The Naked Trader: How anyone can make money trading shares, Robbie Burns, 4th Edition 2014, Page 77

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