CFA Institute Cautions Investors on 12 Common Mistakes
Recognizing How to Avoid Missteps is often the Most Important Part of Creating a Successful Investment Program
By repeatedly committing one or several common investment mistakes, individual investors often prove to be their own worst enemy. Unfortunately, even seemingly simple missteps can, over time, have a dramatic impact on overall returns. Recently, the CFA Institute, which administers the Chartered Financial Analyst® (CFA®) Program worldwide, asked selected members to share their perspectives on some of the most common and costly mistakes they witness individual investors make.
Among the most common mistakes:
1. No investment Strategy. From the outset, says the Institute, every investor should adopt an investment strategy to guide future decisions. A well-planned strategy takes into account such important factors as time horizon, risk tolerance, and amounts to be invested.
2. Investing in individual stocks instead of in a diversified portfolio of securities. Investing in an individual stock is riskier than investing in an already-diversified mutual fund, say CFAs. The CFA Institute says investors should maintain a broadly diversified portfolio incorporating different asset classes and investment styles: “Failing to diversify leaves individuals vulnerable to fluctuations in a particular security or sector.” Also, it warns, don’t confuse mutual fund diversification with portfolio diversification: You may own multiple funds that are actually invested in similar industries and even in the same individual securities.
At the same time, however, the Institute cautions that it is also possible to over-diversify and own too many investment products. The best course of action is to seek a balance between the two which, the Institute’s study says, often can best be done with the advice of a professional advisor.
3. Investing in stocks instead of in companies. Investing, says the Institute, is not gambling and shouldn’t be treated as a hit-or-miss proposition. Investing is assuming a reasonable amount of risk to help finance enterprises believed to have positive long-term growth potential. Investors, for example, should analyze the fundamentals of the company and industry, not day-to-day shifts in stock price. Said one CFA interviewed by the Institute, “Buying a particular stock purely because one likes a company’s product or service is a sure-fire way to lose money.”
4. Buying high. If this is so dumb, why do so many investors do it? The main culprit, says the Institute, is “performance chasing.” Too many people invest in the asset class or asset type that did well in the recent past, assuming that it will continue to do well in the future. But that assumption is “absolutely false.” Lamented one CFA, “The classic buy-high/sell-low investor is someone who has a long-term investment strategy, but doesn’t have the tenacity to stick with it. They throw their strategy out the window in response to short-term movements in the market and invest tactically instead of strategically.”
Others at risk for “buying high” are those who follow investment fads, buying the “hot” stocks of the day. Typically, these investments become fashionable for brief periods, leading many to invest at the height of a cycle or trend — just in time to ride it downward.
5. Selling low. The flip side of buying high can be just as costly. CFA Institute members note that many investors are reluctant to sell a stock until they recoup their losses, because their ego refuses to acknowledge mistakes. By contrast, smart investors are willing to cut their losses when it is time to sell.
6. Churning investments. Too-frequent trading cuts into investment returns. A study by the University of California at Davis examined the stock portfolios of 64,615 individual investors at a large discount brokerage firm between 1991 and 1996. They found that if investors didn’t have to pay transaction costs, they would have beaten the major stock market indexes. But, after transaction costs were included, investors ended up earning 10% less than the market. Clearly, concluded the Institute, the solution is a long-term buy-and-hold strategy, rather than an active trading approach.
7. Acting on “tips” and “sound bites.” Relying on the media is foolish. While breaking news may seem like a promising way to give your portfolio a quick boost, the CFA Institute says you must always remember that you are investing against professionals who have access to teams of research analysts. Believing information that is new to the investor is also new to everyone else is a major mistake. Instead, you should assume that if you’ve heard it, so has everyone else.
8. Paying too much in fees and commissions. Investors are often unable to recite the fees they pay to their investment service provider, says the Institute. Investors should make sure they are fully informed, and all performance data should be adjusted for expenses paid.
9. Decision-making by tax avoidance. While individuals should be aware of the tax implications of their actions, the first objective should always be to make fundamentally sound investment decisions. For example, some investors will let one asset dwarf their other holdings simply because selling it would generate a capital gains tax. Similarly, investors shouldn’t be overly concerned with holding onto a security past the one-year purchase date simply to take advantage of lower capital gains rates.
10. Unrealistic expectations. As we witnessed during the stock market decline of 2000-2002, investors sometimes exhibit a lack of patience that leads to excessive risk-taking. It is important to take a long-term view of investing and not let external factors cause you to make a sudden change in strategy. By comparing the performance of your portfolio with relevant benchmarks, you can develop realistic expectations. According to Ibbotson Associates, the compound annual return on the S&P 500 Stock Index from 1926-2001 was 10.7%, or 4.7% after adjusting for taxes and inflation. Returns on the Lehman Long-Term Bond Index for the same period were 5.3% and 0.6%, respectively. Says the Institute, “Expecting returns of 20-25% annually will set up an investor for disappointment.”
11. Neglect. Individuals often fail to begin an investment program simply because they don’t know how to start. Likewise, people often abandon their long-term strategies after becoming discouraged by investment losses or declines in the stock market.
12. Not knowing your real tolerance for risk. There is no such thing as risk-free investing. In general, says the Institute, individuals planning for long-term goals should be willing to assume more risk in exchange for the possibility of greater rewards, but they shouldn’t wait for a market drop to decide how they feel about risk.
CFA’s are sure to squirm in their seats when you tell them you manage your own investments. Financial planning is part art, part science. Carpentry is as well. We do not see too many non-skilled carpenters building their own home by their own hand. Yet, we see many non-skilled investors attempting to build their own financial house. It is a shame, but nonetheless, the truth.
If any of the above describes you, please give me a call at 704-509-1141, ext. 201, rather than trying to invest on your own.