Investing is a process that works best over time with patience and insight
Many novice do-it-yourself investors lose money in the stock market and would be better off with a professional advisor. We thought it would be useful to understand some of the motivations and mistakes these investors tend to make so advisors can make a compelling case for helping them. Investing is a process that works best over time with patience and insight. Investor mistakes often tend to be made by doing the exact opposite, trying to get rich quickly and following the herd.
People lose money in the stock market because they often think trading stocks is their ticket to getting rich quickly. Social media is littered with stories of wealthy day traders showing off their lavish homes and exotic sports cars, while giving the impression that trading is an almost effortless way to make money. Clearly there will always be a few high-earning traders in terms of investment returns but the reality for most is quite different. In the U.S., a Dalbar study found the average active stock market investor earned about 4% annually between 1997 and 2016, while the S&P 500 benchmark index returned over 10% annually over the same period. Underperforming do-it-yourself investors can let their emotions get in the way, constantly buying and selling hot tips, following the herd, ignoring fees and then impatiently waiting for results that often disappoint and set off yet another round of trading.
Between the media, stock market fluctuations and with a preference for specific assets, it’s hard not to make emotional decisions. One example of emotional investing includes being too invested in a favourite company because you love their product or have friends working there. Emotions make it easy to follow the herd but that mentality is one of the worst behavioral finance mistakes. Herding occurs when one makes investment decisions based on choices others are making without performing one’s own assessment of the available information. All too common as examples are buying simply because the market is setting new records or selling into a correction before it has had time to recover. Surprisingly few people seemed to have learned from the internet boom of the late 1990s as venture capitalists and individual investors poured money into dot com companies. Many of these companies lacked fundamental financial stability but investors, afraid of missing out, continued to listen to the popular press and followed the herd with their investment dollars. Behavioral finance, the marriage of behavioral psychology and behavioral economics, explains how these investors make poor decisions. Everyone wants investments that perform well, but experts say it's dangerous to let fantasies take over and a glance at historical S&P 500 stock market returns shows how buying and selling with the herd can lead to poor returns.
Behavioral finance is also important to understand when it comes to selling a position. Experts know from academic research that selling is hard to do. Getting out of a winner can seem like betraying a loyal friend. Dumping a loser means finally acknowledging a mistake. The pain of losing, the experts say, is sharper than the pleasure of winning. Understanding basic behavioral finance concepts and learning to manage emotions can help avoid a good deal of these losses but the time and effort to do so can be significant. Making one’s own independent assessment can be time consuming and include learning about fundamentals such as earnings before interest, taxes, depreciation and amortization (EBITDA) and technical indicators like relative strength index (RSI).
People often lose money in the markets because they don’t understand economic and investment market cycles. Business and economic cycles expand and decline. Normal growth cycles are fostered by a growing economy, expanding employment, and various other economic factors. Eventually GDP growth slows and the stock market slowly declines in value. Investment markets can also rise and fall very quickly due to global events such as 9/11. In this example, once the New York Stock Exchange (NYSE) reopened after 9/11, the market fell 7.1%, the biggest one-day loss on the exchange and in the following days the NYSE dropped 14%. Investors who sold during that week most likely lost money but if they held fast and had done nothing after the decline, they would have been rewarded. Within a month of the attacks, the equity market was back to where it was just before the attacks. To avoid losing money during a significant drop, the best bet is often to sit tight and wait for the investments to rebound.
When it comes to investing, fees are also very important to factor in, especially for frequent traders. Investors may not realize how much a small transaction fee can eat away at results over time, as that small amount will compound with frequent trading. Fortunately the fee structure of investment firms and brokers is improving but that doesn’t mean there aren’t advisors with high or hidden fees. It’s not always the beginner’s fault when there is so much information to understand about investing, however investors should know there are fees and if they are not paying attention to them, then it is on them for losing money.
Lack of investment diversification, owning too many positions and ongoing tinkering with the portfolio can all be a drag on returns. Potential clients often find ways to overly simplify or complicate their investment portfolio. To avoid losing money in the markets, real investors tune out the outlandish investment pitches and the promises of riches. Showing your emotions and being human can be a great thing. But with investing, emotions tend to create costly mistakes that drive bad decisions. Potential clients may not want to own up to their mistakes and pointing them out may be one of the more challenging aspects to bringing them on board. Advisors can help be helpful by providing an investment plan and the ongoing support to stay with it over the long term.