April 16, 2012
Whether out of fear or greed, investors all too often scramble to do precisely the wrong thing at precisely the wrong time.
Right now, the spectacle that falls into this category of “Stupid Investor Tricks” is the race by investors to allocate more cash to taxable fixed income funds during (a) one of the strongest periods for stocks in the last decade and (b) a time when interest rates are at their lowest levels since the Great Depression, and are being held down artificially by Federal Reserve policymakers.
Investors who put money into bonds – and particularly into Treasury securities – are allocating their capital to something that is far from being the safe haven they imagine the bonds to be. Even if the economy weakens once more, the 30-year bull market for bonds is at an end – interest rates are so low that there is almost no room for them to fall further, meaning there’s no upside potential for bond prices. Meanwhile, yields don’t even begin to protect investors’ purchasing power, especially in the case of Treasury securities. And then there is the probability that rates will rise, which will drive yields down and leave investors who have bought at these levels with losses.
It’s unlikely that we’ll ever manage to eliminate all the possible sources of human error in the investment world. It’s highly probable that human beings, as an asset class, simply aren’t perfectible. But it is possible to reduce the frequency with which individual investors make the kind of obvious and easily avoided missteps that can end up having devastating consequences for their portfolios.
The flurry of interest in bond funds in recent months is just one example of this: At a time when the most experienced financial advisors in the country working with some of the nation’s wealthiest advisors insist that they wouldn’t touch Treasury bonds because the risk of losing capital is simply too great, ordinary investors appear to have no qualms about devoting more money to bonds.
Other stupid investor tricks are easy to spot, too.
One of them is the conviction that all you need is to be able to identify a star manager – you know, the guy who ends up profiled in all the financial magazines after his fund returns 45 percent one year – and invest alongside him in order to emerge a winner. Wrong. For starters, identifying those managers is almost impossible to do in advance – and few of them retain their Midas touch for more than a year or two. Even the remarkable Bill Miller, whose Legg Mason Value Trust (LMVTX) outperformed the S&P 500 for 15 years, eventually saw his winning streak sputter to a halt. And the reason we know Bill Miller‘s name is that his accomplishment is almost unparalleled.
In fact, the more a fund manager is identified as a “winner,” the harder it becomes for him or her to outperform. Investors flood the fund with new capital, and it is hard for the manager to stick to the discipline that got him to star status in the first place.
It doesn’t help that investment management funds cherry-pick the performance figures they want to highlight in the glossy ads you see in magazines or online. If the five-year performance track record looks good, and the three-year track record is horrible, they’ll highlight the former – and you won’t see that the fund’s impressive figure depends on very volatile results, with three years of tremendous gains and two years of high double-digit losses. A fund that is touted as the best performer of 2011 may well never hold that position again. And yet investors still too often use the rear-view mirror to make their fund selections.
A Little Knowledge…
There’s also the comfort factor. If you work within a particular industry, or have a friend or relative who does, you may give yourself greater credit for insight into an investment than you in fact possess. Your knowledge may in fact be greater than that of the man in the street – but unlike that bystander, you don’t have an internal voice warning you to be careful, that you aren’t an expert in this arena. It’s more important – not less – to stop and question your assumptions when you believe you are better informed. Complacency is a big stupid investor trick, and one of the most common ones: Study after study has demonstrated that people routinely rate themselves as above average.
Believing in Patterns
We love patterns – it’s human nature. But patterns aren’t reliable indicators. You know you shouldn’t make an investment call depending on where the hemline of women’s skirts falls, or on who wins the Super Bowl. But plenty of people will still look for patterns in relative valuations of large and small cap stocks, for instance. Patterns break down over time: Just look at the way the investment world has been reshaped over the last 20 years, with the emergence of countries like China and Brazil and the newfound fragility of the Euro. How can you draw a sensible conclusion about the relative value of the dollar, the euro and the Chinese yuan based on historical trends, as the relationships between the three economic zones are being rewritten as I type these words?
Some tips for avoiding stupid investor tricks:
- Look at your portfolio and decide whether you would still buy the stocks or other assets it contains today at their current prices, with any free cash you have. If you can’t rationalize that, and there aren’t any tax consequences that flow from selling it, create a plan to do just that.
- Why are you planning to invest more in bonds (or whatever else you are on the verge of buying)? Is it out of fear? A desire for yield? Have you really pondered the future prospects, or is your decision to invest a “default decision”? Consider what some alternatives might be that would get you to the same ends. For instance, if you’re looking for yield and safety, perhaps highly-rated muni bonds or dividend yielding stocks are a better solution.
- Question your assumptions; research an idea and don’t pull the trigger until you feel you are able to act dispassionately instead of out of fear or excitement. If you feel emotional about a decision you’re making about your portfolio, odds are that you’re on the verge of a stupid investor trick.