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Top 10 investor mistakes

Created:
31 December 2008
Written by:
Nick Louth

"Alliance & Leicester is worth holding for a bid premium... Royal Bank of Scotland has confirmed its growth credentials by beating Barclays to buy ABN Amro... The Competition Commission would never let any of Britain's top five banks merge... Northern Rock looks a bargain... Housebuilders will do okay even if prices fall because of their landbanks and the shortage of homes."

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Eighteen months ago these views were uncontroversial. Millions of investors believed them. With the precision of hindsight, we now know they were wrong. The decisions that flowed from these mistaken views have lost investors tens of billions of pounds.

Every investor, professional or amateur, expert or beginner, makes mistakes. The most successful investors admit to them, some even rejoice in them. George Soros, in his 1997 book The Crisis of Global Capitalism said of investing mistakes: "Most people are reluctant to admit that they are wrong; it gave me positive pleasure to discover a mistake because I knew it could save me from financial grief."

Most investors perhaps don't have the self-confidence to enjoy the pain as Mr Soros does. But, even if they hate it, they'll still get plenty. Even in a typical year, when the FTSE 100 rises, say, 10 per cent, significant mistakes can turn profits into losses, and drag performance well below the market average. However in 2008, with the stock market heading for its biggest fall since 1974, the consequences of mistaken judgments are a whole order of magnitude larger. They can easily wipe out an entire portfolio.

Mistakes compound each other, almost like inverse compound interest. If you thought Northern Rock was a bargain in September last year, when it seemed to have half the price earnings (PE) ratio of its rivals, that might have been error number one. If you didn't re-visit your research when it became clear that Northern Rock relied much more heavily on wholesale money markets than its rivals, that was boo-boo number two. If you didn't run stop-losses, but were a resolute buy-and-hold merchant, then those losses would have been compounded, that was a real clanger, number three. If you looked back to the share's previous peak, and expected an eventual return to that height, then you were fooling yourself, mistake number four. If that was your only share, and you happened to be employed by the bank as well, that was a disaster.

Most of the mistakes investors have made since this financial crisis began have been the traditional ones, described below.

However, two different types of investing error have loomed larger this time than in the normal run of the mill market experience: Impatience and resisting new realities.

All your eggs in one basket

There are very few mistakes that can lose you all your money in one go, but this one can. If you have just one share in your portfolio, you are running a major risk even if that share seems rock-solid. Supposedly safe firms do collapse, sometimes overnight, leaving investors with next to nothing. Recently we’ve seen this at AIG, Lehman Brothers, Bear Stearns and others. Barings was unusual in that its 1995 downfall was caused by just a single rogue trader. Normally, it's the board's doing. Enron was a utility, supposedly safe, but top executives were doing some very unsafe things with its money, creating secret accounts where liabilities were hoarded. Learning nothing and forgetting nothing, many of the world's banks seem to have done exactly the same through structured investment vehicles (SIVs) in the past five years. The 'one basket' this time around includes sectors, too. If you had all your shares in UK banks, something that wouldn't have seemed particularly risky over most of the past 50 years, you could have easily lost 75-90 per cent of your money in the last 18 months. If you hold shares or options in your employer, have a company car, company loan or mortgage and your partner works there too, the same risk applies to you. That is an awful lot of eggs in one basket, even if that basket appears to be safe.

Not selling losers

Almost every investor makes this mistake from time to time, but some never get a grip on it. Selling losing investments is a vital discipline without which it is tough to outperform the market. The aim of all portfolios is for investment cash to be harnessed to winning companies whose values are increasing, not stuffed into losers on the premise that after falls they represent an ever-increasing bargain. The real difficulty comes when a share is falling while fundamentals remain sound. The difficulty is compounded further when, as now, entire portfolios of shares that are probably solid are sliding together because of weak sentiment. In any case, the discipline to cut losses quickly is hard, because it means ignoring the price you may have paid (see anchoring), but it pays for itself time and time again.

Anchoring expectations

This error is simple and unconscious. It explains why investors hang on to losing stocks, but is also an investing flaw in its own right. Northern Rock looked a bargain to millions purely because it was down by 90 per cent from the peaks of 2007. That price became the anchor of expectation which many bargain hunters hoped would, at some time in the future, be regained. It is now clear that the banking sector of 2009 and beyond will be very different from that which prevailed in the 1990s, yet it hasn’t stopped HBOS, Lloyds TSB, RBS and the rest topping the lists of brokers' 'popular buy' charts all the way down to the bottom. The real value of a share is nothing to do with past prices, but is determined by the expected future flow of dividends and earnings. The same anchoring that inhibits the sale of losing shares also encourages hasty sales on winning shares. Even if you have tripled your money, it is considering whether valuation is stretched that should lead your decision to sell, rather than an arbitrary price target.

Neglecting research

Researching investment ideas is far easier than it used to be. Stock screens help you sift out the type of company characteristics you want, whether it is high and sustainable dividend yields or low debt ratios. Endless websites and investor tools, most of them free, home in on the metrics that are important, even down to cash flow and analysts' average projections. Yet, despite this, many investors make only cursory checks on the shares they buy. Those who pick shares in companies whose business and industry they do not understand will not notice the early warning signs of poor performance, and tend to be left holding the baby when more savvy operators have bailed out. Even half an hour of research before making a purchase can make you feel a lot more confident that you know what you are investing in. Certainly, few of us would buy a car or even a new TV without shopping around. It would be daft not to do at least as much before spending thousands of pounds on an investment.

Being a sheep

Buying what everybody else is buying and selling what they are selling can seem moderately profitable as momentum takes a long time to turn. That's fine if you are in at the beginning, not so good if you are last to follow the flock. However, being a follower creates no better than average returns because you'll tend to buy expensive and sell cheap. Contrarian investing, being the black sheep, goes against the investment grain by seeking out neglected value. Just because everyone else is steering clear of a stock doesn't necessarily make it a bad investment, but it does justify in-depth research. Just a few good contrarian moves every year can lift a portfolio above the mundane. Best of all, when the flock wanders round to your way of thinking you can sit tight and watch your brave picks get the attention and share price appreciation they deserve.

Buying on borrowed cash

Leverage is the classic two-edged investment weapon. It allows you to outperform when the market is doing well, but is a ferocious foe in a downturn. The spectacle of overpaid hedge fund managers selling anything liquid to repay borrowings and forced redemptions in the past three months is not something we can be detached about, as it has had such a calamitous effect on the broader market. But managers should need no reminding that it is always when it is raining hardest that lenders want their umbrella back. The truth is that, in the long term, the cost of debt eats up almost all average market equity returns, leaving little to reinvest. On a risk-adjusted basis, it can hardly be otherwise as both sources of capital compete. Those that gamble on the carry trade do so at their peril.

Too much caution

Caution is good, but too much can damage your returns. You can safely predict that millions of people in 2009 having read the headlines in the last year or two will never even consider investing in shares, or take out a share-based pension, even though prices are by historic standards extremely attractive. Their caution will drive them to put all their money in savings accounts or gilt-edged stock, which eliminates one bogeyman, risk, but ignores a much bigger one, underperformance.

Indeed, according to the Barclays Equity-Gilt study, there is a 99 per cent probability of equities outperforming cash savings over a period as short as 18 years. Although no end of current newspaper articles point out that share prices were higher in 1998 than they are now, they neglect to account for the power of the reinvested dividend. The 6 per cent yield on the FTSE 100 prevailing now will actually double your money in 12 years even if share prices don’t budge. Over longer periods, the gains are astronomical. £100 in equities at the end of 1945 with dividends reinvested would be worth £131,000 now, but £100 in savings would be only £5,789, according to the study.

Failing to monitor your holdings

Buy and hold is one thing, but it does pay to reflect on your portfolio once in a while. If there is one thing that the current downturn has proved, it's that even the biggest companies can get into trouble. Whether it is BP or Vodafone or Royal Bank of Scotland, you need to keep an eye on news and sentiment. If you want to run any kind of stop-loss system, you will have to keep a close eye on your most volatile stocks anyway. This is in addition to making sure you know when results, shareholders' meetings and investors' presentations are due. For those whose investments are in funds, monitoring perhaps doesn't have to be onerous, probably a monthly or quarterly check is enough.

Nevertheless, fund investors shouldn't sidestep those same key issues that shareholders must deal with. What's the right amount to have in cash? Have I too much or too little exposure to a given sector? Where are emerging markets/commercial property/commodities going this year?

Overtrading

Traders try to make money by second-guessing the market's valuations for stocks and indices on a daily or even hourly basis. A few do well, but the average trader by definition cannot make consistent money, any more than the average football team can end up anywhere but at the middle of the league table. Overall, profits and losses balance out even before the cost of commissions and the time involved is accounted for. This truism has seemed to escape those who spend thousands of pounds on trading courses which purport to put them in the top 5 per cent. Still, you don't have to trade every day to trade too much. A portfolio in which the average stock holding period is three months is losing 2 per cent a year just on stamp duty. That's without counting bid-offer spreads, commission – and, of course, your own time. At, say, 3 per cent a year, you've eaten up what the FTSE 100 typically pays in dividends. Investing is a hare and tortoise game: those who trade frequently run the risk of squandering small but sure long-term profits in pursuit of larger but unsustainable short-term gains.

Resisting new realities

The usual refrain in market bubbles is "it's different this time". It is used to justify astronomical PE ratios, one-product-wonder companies, and world-changing marketing promises. These claims almost always prove illusory. However, as far as market collapses go, it really has been different this time. The world really has changed, and what has changed is the death of belief in banks. Investors who have owned banks for decades have enjoyed the hefty profits and fat dividends generated by familiar brands in seemingly unassailable market niches. But now the earth has opened up beneath their feet. Northern Rock and Bradford & Bingley have been fully nationalised, Royal Bank of Scotland is going to be majority state-owned, while the seemingly impossible idea of a merger between two of the big five banks, Lloyds TSB and HBOS, was not only allowed by the government, but positively encouraged. This year, like the Red Queen in Alice in Wonderland, we've had to believe as many as six impossible things before breakfast. Those that failed to digest the lesson have suffered severe investment pain.

Impatience

Impatience has always got in the way of profit. It forces quick sales for small profits, prefers the glittering promise of capital gain over the subtler virtues of dividends, and loves to over-trade. But in 2008 it has really come into its own with bargain hunters. Eager investors with cash to burn have squealed with glee over housebuilders, banks and retailers whose shares had halved. Retailer M&S for the first half of this year traded around 400p, little more than half its peak during the previous year. Small investors piled in, but worse news in the third quarter helped the shares halve again. While the shares of M&S and many other durable icons of Britain's economy may well recover somewhat, it is the most patient investors who have really got in cheap. With banks, even a month's patience would have made an enormous difference. The last halving in Barclays, HBOS, RBS and Lloyds TSB has taken less than six weeks.

MORNINGSTAR'S 10 FUND PITFALLS TO AVOID:

1. Undefined objectives and priorities. Your investments are there to do a job? What is it and are they doing it?

2. Lack of focus. For each goal you have identified, you should have a core group of three or four funds that are proven offerings.

3. Too many extras. Use additional funds to diversify and for growth potential.

4. Loss of balance. Are you overconcentrated in asset classes, regions or investment style?

5. Too many funds. Evaluate the funds you hold. Are they core or not? Could you own fewer funds?

6. Poor choices within categories. If too many of your fund holdings use a similar approach and invest in the same kinds of stocks, keep the strongest and sell the weakest.

7. Focusing on too much income. Have you taken on too much credit risk by focusing on income funds? Is your capital base being eroded?

8. Paying too much in fees. Always check costs and compare TERs. Fees make a huge difference to performance

9. Poorly defined sell criteria. Establish your sell criteria. What will you do if the manager leaves or if the fund loses 15 per cent? How long will you accept poor performance? Think through your answers so you know when to sell.

10. Reluctance to seek professional help. Professional guidance can be invaluable even for DIY investors.

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