What Is The Most Common Mistake Investors Make?

on Monday, 15 September 2014. Posted in , , ,
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This article was originally posted on Talk Magazine Shanghai September 2014 edition.

 

oops-eraser-mistake-630Without doubt, the most common mistake individual investors make is trying to time the market. Neither individual nor professional investors are able to make consistently accurate calls on when to buy and sell their investments. There are a number of expensive newsletters that claim they have the secret to market timing, but just the fact they are selling a newsletter rather than investing is evidence in itself that they don’t have all the answers.

When individual investors try to time the market, they are much more likely to buy and sell at the worst possible times. Individual investors tend to use their emotions to decided when to buy and sell, investors suffer great pain when pessimism is rampant and stock prices fall. They are more likely to buy when everyone is upbeat and prices are near or at their peak. Emotional decisions cause investors, all too often, to shoot themselves in the foot.

When prices are high and returns have been good, individual investors tend to pile into equity funds; when prices are low, investors get worried and tend to sell their equity holdings. It’s strange that the stock market is the only place where buyers are wary of discounts and prefer to buy after prices go up substantially.

skd283925sdcIn the first quarter of 2000, which coincided with the top of the Internet bubble, more new money was invested in equity mutual funds than ever before. Then in the fourth quarter of 2002, which turned out to be the market bottom after a sharp decline in stock prices, investors pulled large amounts of money out of equity mutual funds. Then, in the third quarter of 2008, during the worst of the recent financial crises when stocks made decade lows, investors redeemed unprecedented amounts of equity mutual funds. Our emotions lead us to sell at bottoms and buy at tops, not a recipe for success.

Several studies have tried to measure the cost of bad timing decisions. They all agree that individual investors tend to do much worse than a buy and hold investor who avoided market timing altogether. A well-known study of the so-called “behaviour gap” estimates that it may be as large as five to six percentage points annually over the past 20 years. Other studies have estimated somewhat similar or smaller gaps, but all of the studies agree that emotional investor decisions are extremely costly. Investors can be their own worst enemy.

As an investment advisor, one of the most important parts of the job is to rein in the emotions of clients and provide a degree of rationality. If you are convinced a buy and hold strategy is for you and would like to limit portfolio volatility, I would recommend a looking for a diversified portfolio of broad based index funds, ETF providers such as Ishares, SPDR and Vanguard are a good places to start.

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