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September 22, 2010

Avoiding the 10 Most Common Investor Mistakes, Mistakes 4-7

The following is an excerpt from 20 Retirement Decisions You Need to Make Right Now . Over the next few days Ill be posting all of the 10 most common investor mistakes, so stay tuned to see them all.

Mistake 4: Chasing Returns

Individual investors are famous for buying last year’s winners. Guess which mutual funds attract the most new money each year? You got it; money flows into mutual funds that have just enjoyed the greatest performance in the previous year. In 2007, for example, investors poured more than $208 billion into international funds, the asset class with the greatest performance in 2006. The returns of the three international funds that brought in the most assets in 2007 provided returns 10 percent higher than the U.S. stock market in 2006. In 2008, however, these same three funds on average lost 42.96 percent. International funds were the worst major equity asset class in 2008. In other words, investors who chased market-beating returns in 2008 got soundly beaten by the market.

It shouldn’t be surprising that chasing returns is a very common investor mistake. There’s an entire financial media industry built around one simple theme: “Don’t Miss Out on the Ten Hottest Stocks,” or some variation of it. For many investors, the lure of phenomenal past returns is just too tempting to pass up. This allure leads to critical mistakes.

For example, in 1999, the Nicholas-Applegate Global Tech I Fund posted an unbelievable 494 percent return, and investors saw instant riches parading before their eyes. An individual investing in this fund at the start of 2000, however, experienced the following returns: -36.37 percent in 2000, -49.26 percent in 2001, and -44.96 percent in 2002. At the end of three years, a $10,000 investment was worth just $1,777.

When the fine print says “Past performance is no guarantee of future returns,” believe it!

Mistake 5: Believing Persuasive Advertising Messages

Many brokerage firms advertise in order to convince you how easy, enjoyable, and inexpensive it is to delve into the stock market and make big money. In fact, the brokerage industry spends hundreds of millions of dollars each year on TV commercials persuading us that it’s easy to be a success in the market.

The most classic example is the series of Stewart commercials run for a large brokerage firm that was touting its online trading system. You may remember Stuart? He was that red-headed, punk rocker who taught us and his boss how easy it is to make money in the stock market. Stuart advised that all you had to do was open an online account, start trading, and watch the money roll in. As Stewart said in the commercial:

“I don’t want to beat the market. I wanna grab it, sock it in the gut a couple of times, turn it upside down, hold it by the pants, and shake it ’til all those pockets empty out the spare change.”

Although the Stuart commercials, like many ads for the investment houses in the late ’90s, were hilarious, they did more damage than good. In fact, the commercial is even funnier in hindsight. In one of the 1999 commercials Stewart recommends that his boss buy one hundred shares of Kmart stock. In 2002 Kmart filed for bankruptcy, and the value of the stock subsequently went to zero. We don’t see Stuart talking about investing anymore, probably because he lost his shirt in the 2000–2002 recession. He learned the hard way that there is more to developing a solid investment strategy than merely opening an online brokerage account and trading.

No question about it, buying and selling stocks can be exhilarating. Many investors roll up their sleeves and play with their money, checking stock prices and market values throughout each day. While this may be a great form of entertainment, most discover it’s also a successful formula for losing money.

Rarely a day passes when a brokerage firm isn’t telling Americans that they can trade stocks for as little as $5 to $8 per transaction. Think about it. By offering such cheap trades, these firms have to make up for it by dealing in quantity. Their goal is to have you trade as often as possible without concern for cost. What they don’t tell you is what it’s really costing you. As we’ve seen, hyperactive trading equals poor performance.

Mistake 6: Poor Diversification

Investors tend to be concentrated in one or two companies or sectors of the market. Overconcentration can hurt a portfolio, whether the market is performing well or poorly. Poor diversification leads to excessive volatility, and excessive volatility causes investors to make hasty, poor decisions.

Suppose in 2008 you had placed the bulk of your portfolio in a big company like Lehman Brothers (-99.18 percent), AIG (96.24 percent), General Motors (-86.86 percent) or Citigroup (-73.40 percent). That year, you would have watched your portfolio head into an unrecoverable tailspin. Many Lehman employees invested a large portion of their retirement plan money in their company stock. You are probably thinking, “Who would invest the majority of their nest egg in just one company?” Surprisingly it is fairly common. A little more than one out of every ten people who have the option of buying shares of their company stock in their retirement plan have invested at least sixty percent of their retirement plan money in their company stock. People who had concentrated the bulk of their portfolios in these companies saw values drop to almost zero. Many were left with no other option but to start from scratch and begin rebuilding an entirely new portfolio.

You would think we’d learn. Many investors who got caught up in the technology craze of the late 1990s suffered a similar fate. Staggering amounts of money poured into technology mutual funds as investors bulked up their investments in this single market sector. This lack of diversification proved fatal for technology investors when the average tech fund fell 30.7 percent in 2000, another 35.2 percent in 2001, and another 42.73 in 2002. By comparison, a well-diversified growth portfolio consisting of 80 percent stocks and 20 percent bonds would have fallen just 4 percent in 2000, 8 percent in 2001, and 13 percent in 2002. When volatility is controlled, it’s easier for investors to maintain a long-term investing outlook.

Another lesson from history shows that poor diversification even takes its toll during rising bull markets. In 1999, the S&P 500 Index recorded a 21 percent return. However, just eight of the 500 stocks in the index accounted for half of its 21 percent gain. The odds were stacked against the investor who bought just a few S&P stocks during 1999. The chances of an investor successfully choosing those eight big winners out of 500 would be a little better than winning the lottery. Most investors would be far more successful by simply diversifying, buying an S&P 500 Index fund, and owning stakes in all 500 companies.

Mistake 7: Lack of Patience

Most mutual fund investors hold their funds for only two or three years before impatience gets the best of them. Individual stock investors are even less patient, turning over about 70 percent of their portfolios each year. You simply can’t realize good returns from the stock market if you invest for only weeks, months, or even a couple of years. When investing in stocks or stock funds, investors must learn to set their investment sights on five- and ten-year periods.

Investors would do well to study the example of the CGM Focus fund, which has the best ten-year annual return for the period ending June 30, 2009, as measured against all large-company U.S. stock funds. During that decade, this stock fund provided investors with a stunning annual return of 16.03 percent. A $10,000 investment in the CGM Focus fund would have grown to $47,250 during this period. Most investors, it’s safe to say, would be very happy with this performance. However, it didn’t deliver huge returns every single year. In fact, during that 10-year period two years were pretty rough, losing -17.79 and -48.88 percent. An investor would have had to endure these two negative years (years when an FDIC bank account would have done much better) to gain the 16.03 percent long-term average annual return. Patient investors were rewarded.

Anne Scheiber is a model of patience that all investors should emulate. She retired from her $3,150-per-year IRS auditor job in 1943. At that time, she invested $5,000—a little over one year’s salary—into a portfolio of stocks. Over the years, she bought and held mostly blue-chip U.S. stocks and some municipal bonds. She didn’t worry about daily market fluctuations and rode out the difficult market periods. When Anne died in 1995, at age 101, her $5,000 had grown to more than $22 million, which she donated to a Jewish university. Patience was at the core of Anne’s stunning investment success.