By Moshe Silver
The SEC wants to remind you, Mr. & Mrs. Average Investor, that it really does care about you. Earlier today, the Commission tweeted out a reprise of a 2010 report produced by the Library of Congress, at the request of the SEC Office of Investor Education and Advocacy. The report highlights nine major reasons that your investment portfolio routinely underperforms.
For all our jaded skepticism about the SEC, their investor education pieces often point to real issues that plague private investors in their quest for profits and financial stability. While today’s tweet doesn’t tell you how to invest successfully, it does tell you nine specific investing behaviors that are almost guaranteed to decrease your chances of success. For that alone, it’s worth a look.
Today’s tweet is aimed at individual investors. Bur here’s a tip from the Dark Side of Wall Street: the same behavioral patterns that have consistently made you a losing investor in the markets also plague the majority of investment professionals. That’s why hedge funds as a class generally can’t outperform the broad market averages, or each other. (See, for example, “Hedge Funds Trail Stocks For Fifth Year With 7.4% Return,” Bloomberg, 8 January 2014). The article notes that “hedge funds last beat US stocks in 2008,” by losing less than the broad market (hedge funds down 19% as a group, versus a 37% decline in the S&P 500 – do you feel better now…?)
Active Trading: Says the SEC, “the Report concludes that active trading generally results in the underperformance of an investor’s portfolio.” Excessive turnover in your trading account hasn’t led to outsize profits – but it has contributed to the profits of the high-frequency traders. Thanks for playing.
Disposition Effect: Holding onto your losers, and selling your winners.
Focusing on Past Performance of Mutual Funds, While Ignoring Fees: Past annualized returns, as every prospectus is required to warn you, are not a guarantee of future results. But heads up: past management fees, transaction costs and expense ratios generally are an accurate guide to what the managers of a fund will be taking out of your pocket, meaning no matter how well or poorly they do this year, you still have to claw your way back from that added 1%, 2%, 3%, or even more before you start actually generating profits. If your mutual fund hits the hedge fund average of 7.4%, as noted by Bloomberg, but you pay 2.5% in expenses, how well did you actually do? Are you smarter than a fourth grader?
Familiarity Bias: People “tend to favor investments from the investor’s own country, region, state or company.” “I only invest in what I know” is a form of self-inflicted affinity fraud. This lazy approach leads to a haphazard and lopsided portfolio with no strategic plan.
Manias and Panics: The reason markets make bubbles is because everyone rushes in to buy as the price inflates. The faster the price inflates, the more buyers panic and rush in. When the last hysterical buyer has bought, there’s no one left to buy. “Pop!” goes the bubble. Tulip bulbs, anyone?
Momentum Investing: The financial equivalent of not looking at a weather forecast. “Tomorrow is likely to be just like today,” you reason. “Stocks went up today, so they’ll go up tomorrow. I can buy them now on the way up, and I’ll sell them before they go down.” ‘Nuff sed…
Naïve Diversification: You’ve been told you should diversify your portfolio, so you put 10% of your money into each of ten different investments without regard for varying levels of risk, broad market forces, or the potential for interactions that may magnify risks across the investments you have chosen. “Diversification” doesn’t mean “buy lots of stuff.” It means “buy a lot of uncorrelated stuff” so your holdings won’t all go up or down together.
Noise Trading: Following trends after they have become widely known. If the headline on the front page of the financial section screams “Gold At All-Time High!” and you rush out and buy gold, you are a noise trader. Says the Commission, you “have poor timing, follow trends, and overreact to good and bad news in the market.”
Inadequate Diversification: Last but not least, the Report identifies a tendency on the part of investors to buy a number of different stocks, but all in the same one or two sectors. Buying five transportation stocks and seven natural resources stocks is not diversification. If anything, it is excessively concentrating your portfolio in two closely correlated sectors. It’s almost the equivalent of buying one stock, closing your eyes, and hoping for the best.
Moshe Silver is chief compliance officer at Hedgeye and author of Fixing a Broken Wall Street.