THE SEVEN DEADLY INVESTOR TRAPS

Are you caught in the seven deadly investor traps?  Do these traps sound familiar?

Trap #1: Gambling with your money

I’m not saying that all gambling is bad. If you enjoy taking some disposable income and going to Vegas, or buying a lottery ticket, and it is money you can afford to lose, it may be an enjoyable activity that is valid for you as an individual. Where I take issue is when people gamble and speculate with the financial wealth that they need for their retirements and for their futures. Simply said, Don’t gamble away your investment capital.

Obviously, not all investing is gambling because the brokerage community, news programs, mutual funds, and magazines all blur the lines that separate speculating, gambling and investing, most individuals are speculating and gambling with their money – and they don’t even know it. They actually mistake gambling and speculating for prudent investing. How does this happen?

It happens because the media and the financial community have formed an “unholy alliance.” You often turn on a news program and see “experts” and analysts talking about their forecasts for the future, or what stocks they like; they’ll actually say what to buy, what to sell, what to hold, and so forth. This is the infamous “Buy, Hold, or Sell” recommendation. The media needs these types of recommendations because that’s what gets people to tune in. They need highly speculative, adrenalin-driven, or fear-driven reports, and stories to keep people watching and keep the advertisers happy. Who are the advertisers on these pseudo news-investing programs? Many times, they are the very same companies that provide the experts to begin with.

This is a mind boggling conflict of interest, and yet it goes on every day.

But the two can be easily confused. Every day investors take imprudent risks with their investment capital.

There are three types of speculating and gambling with your investment capital that you must guard against.

1. Trying to pick the best stocks. What’s the next hot stock or group of stocks going to be? This includes stock-picking or even buying a seemingly diversified group of 100 or fewer stocks and holding them for several years. If you hire a manager who tells you what the best stocks are, such as a mutual fund, the manager often practices stock picking. In this instance the average turnover in American mutual funds is 100% per year. That means they are selling everything, wiping it all out, and buying all new stocks once every year. That happens year after year, after year, and they’re doing it with your money, without your knowledge.

2. Trying to time the market. When assets are moved in the portfolio, based on a forecast or prediction about the future, this is market timing. For example, you’ve become convinced by economic forecasts that the market is heading down over the next twelve months. You decide to sell your stocks and put all of the money into cash. That is market timing! Market movements are random. No one knows what the market will do tomorrow or over the next twelve months. It bears saying again:

nobody knows with any certainty, and if they did they wouldn’t tell you!

Let’s look at another example. Because of a war, you or your broker predict that international stocks are going to lose big, so you move all of your stocks into the United States . Once again, this is market timing. This doesn’t “feel” like speculating. It often feels like wise stewardship of your assets. If over the last two years, you have watched your portfolio take large losses in any one asset category, and every news program, investing magazine, and stock broker says this is the time to get out – it feels like prudent investing. Nothing could be further from the truth. In many cases, if not most, staying disciplined and staying the course is the best thing to do. That assumes that you currently have a prudent mix of assets. This is a huge assumption, because most people don’t.

3. Track record investing. The last way you know you’re gambling and speculating with your money is track record investing. Track record investing entails going with the manager, much like betting on a horse that had stellar performance in the past. The manager might have 5, 10, 15, or 20 years of beating the market and you’re hoping that he’ll continue to do that into the future. The vast preponderance of evidence shows that you might get lucky and beat the market, but academic studies prove that most likely you would achieve less than a simple market return.

All three of these types of speculation entail a forecast. Someone is trying to forecast and predict what will happen in the future. Whether you yourself are doing it or you’ve paid someone else to do it doesn’t really matter, because in my view it’s still speculating and gambling with your money, and they get paid big bucks for doing it.

Trap #2: Mistaking a lot of “stuff” for true diversification

Investors believe that if they have a lot of items on their statement, they are diversified. So, for example, if an investor goes out and buys a collection of one hundred different stocks, he might think when he gets his statement, “Wow, I’m really diversified. Look at all these companies.” In one sense, this hypothetical investor does have some diversification. If any one company goes under, the rest of his or her holdings could save the portfolio. But in a greater sense, this type of portfolio could have far more risk than an investor could ever imagine.

For argument’s sake, let’s say that all of those companies are in one asset category, such as the S&P 500. Given anecdotal evidence, the investor is told by his broker that these are very large and stable companies. What the investor is not told, is that because all of these companies are in only one asset class, that they tend to move in a step-rate fashion, and when one crashes they all tend to crash together. So, when that market crashes, chances are the investor is going to lose massive amounts of money. The largest, supposedly safest U.S. stocks that make up the S&P 500 lost over 43% for the three year period starting January 1, 2000. Why? Because the vast majority of the stocks move together! Even owning 500 stocks does not mean you are prudently diversified.

Many Americans fell into this trap in the early 2000s because on the advice of brokers, planners, and the media, they loaded up on large U.S. companies and technology stocks.

The vast majority of them felt and believed they were diversified. They were not.

The United States stock market value was decimated to the tune of $8 trillion at the beginning of the new millennium. This was money that investors were counting on for retirements and the stability of their futures. When I meet with investors, I ask them “Did you know you could lose so much money?” They always say “no”. Not a single investor or advisor I have talked to had any idea they could lose so much money. Investors in technology stocks saw even worse losses, as the tech index dropped more than 60% during the same period.

Most investors were aghast to see their portfolios tank.

They had no idea that could happen. They felt they were safe and protected. Most were not. Here the “crime” was not that the market dropped, because all markets rise and fall. The crisis was created because investors felt they were protected, and no one took the time or had the fortitude to show them what could, and eventually would, happen to their assets in poor markets. Investors were kept completely in the dark. Today, I work closely with brokers and planners to help them transition into coaching and help solve these problems for their investors. The sad truth is that most brokers and planners were themselves ignorant of the real risk inherent in the portfolios they recommended. Never mistake a lot of stuff for true diversification.

Trap#3: Mistaking activity for control

One of the investing commercials that makes me sick to my stomach is the one where the father is in the den, trading on the computer: “Buy, sell, blah, blah, blah.” And then, he asks Annie to come in. You are led to believe that Annie is his assistant or secretary, instead Annie is his four-year-old daughter. This commercial epitomizes the belief that if you buy and sell frequently you will be in control of both your portfolio and your own destiny. It portrays this buying, selling, and speculating glut as healthy, and even goes as far as intimating that if you trade at home you can be an even better father and family man. Perhaps a more accurate portrayal would highlight an ego-and-adrenaline-driven father taking time away from his family to compulsively trade.

At the risk of sounding bitter, the sound bite should be: “Annie, come in here and watch Daddy trade away your college money.”

We’re led to believe that if we buy and sell, buy and sell, buy and sell, we are in control. Here, we must explore the difference between real control and the false sense of control that trading, stock picking, forecasting, and track record investing create.

You will probably lose money by playing.

The more frequently you trade, a larger part of your return is sucked out of your portfolio in the form of commissions, market impact, and bid/ask spread costs. The more actively you trade, or your money is traded inside of a mutual fund, the greater the burden of trading costs on your portfolio and the lower your chance of beating the market or even achieving a market rate of return.

Trap #4: Believing all risk is equal

Many a time, we’ll see someone doing something very imprudent with his money, and we’ll say, “Well, you’ve got four million dollars, and you only own four stocks. That’s not very prudent.” The investor will say, “I know that it’s very high risk, but risk and reward are related; therefore, I’m taking all this additional risk and I will be rewarded.”

There’s a big hole in that theory. The fallacy is that all risks are equal.

For example, if I told you to take a nine iron in a rain storm, go stand on the highest hill of a golf course in the thunderstorm, and hold it up in the air for an hour, what is the expected payoff for that risk taking? Best case scenario, you could get wet, you might get a cold. That’s the best case scenario! There is no expected positive return from that activity.

In this case you’re taking huge amounts of risk. Are you expected to be rewarded? NO, you are not!

One very likely outcome is that you could be struck dead by lightning! There is no positive expected outcome for taking that type of risk.

In my belief, taking risk for its own sake is a crime in and of itself because it puts you in a position where your capacity to live fully and to enjoy your wealth is greatly diminished. Why would you ever do that? It is an act of self abuse. And yet, it goes on every day.

Another form of this is ignoring the sum of all outcomes when investing. For example, imagine that someone handed you a gun with one bullet in the chamber. It is a six shooter, so five of the chambers are empty. You are told that the chamber has been spun and no one knows where the bullet is. You are instructed to put the gun to your head and pull the trigger. If the chamber is empty and you live, you will be rewarded with ten million dollars. If the chamber contains the bullet, you will die. What would you do? Of course, investing is not identical to Russian Roulette. But, in both cases, all risks must be calculated and analyzed.

Indeed, you would be foolhardy at best to ignore the possible outcome that you would blow your own brains out.

That very real possibility must be factored into your decision making process. To focus only on the ten million and ignore the risk could have dire results. Yet this type of risk-taking goes on continuously when it comes to investing. Many investors, brokers, and planners ignore, to a large extent, examining and exploring just how bad and ugly things could get with any given investing strategy.

There is a distinct possibility that without an unbiased analysis you may not even know that the gun is loaded. Focusing on the sum of all outcomes means studying and analyzing all of the possible negative outcomes and factoring that into your decision making process. By incorporating this into your process, you can separate prudent risk-taking from imprudent risk-taking. In other words, separate true investing from market speculation.

Prudent risk-taking has a very high statistical likelihood that you will get additional return for that risk. Imprudent risk taking is risk taking that has little or no correlation with the likelihood that you will receive additional premiums or rates of return for taking that risk. This can be thought of as holding the golf club up in the rain storm. Distinguishing prudent from imprudent risk-taking in one of the investor’s primary jobs.

Trap #5: Trusting your Broker

Commercials and the credibility of large financial institutions lead investors to believe that the brokers work for them. The broker works for the broker/dealer, not for the individual! It’s the broker’s job to promote and sell what the broker dealer tells them to promote and sell. The broker/dealer has a vested interest to maximize the profits of its own stockholders. The broker works for the large institution, not for you. The interest of the bureaucratic broker/dealer may or may not be in your best interest. The stock broker is often not much more than a glorified salesperson. I am sure there are many honest well-meaning brokers who care about their clients.

There’s nothing wrong with that. Salesmen and saleswomen make this country run. There’s nothing wrong with the act of selling, and that’s the broker’s job, to sell product. That is why they are in business. If the investor understands that there is a built-in conflict of interest, I see no problem with this arrangement.

It is – BUYERS BEWARE!

For those investors who do not fully understand the implications of this relationship, the results can be disastrous. If you go to buy a Ford at a ford dealer and you talk to a salesman, you know he’s going to push a Ford. You don’t expect to get unbiased advice from a salesman at the Ford dealership. But, when going to a broker, investors often expect unbiased advice. As if a Ford dealer would recommend a Toyota – guess what, it’s not going to happen. Investors just have to be smart enough to know where the conflict of interest is and understand that what may be good for the broker, may be bad for the investor.

Trap #6: Believing that this time it is different

By studying the history of markets, there is a clear pattern of this problem rearing its evil head over and over again. Lets look at the most recent case.

I call this the “New Paradigm” Problem.

In the late 1990s, we were all led to believe by the brokerage community, newspapers, media, the TV shows, the futurists, the financial magazines, and financial advisors that we were in a “new paradigm.” It was a very seductive and compelling story. It went something like this…

“We are in a new paradigm, and because the Internet is the most powerful technology known to mankind, it will shape the future of business and investing. It will reshape reality. It is making 21-year-old kids instant millionaires. Even janitors in many technology companies are getting rich from their stock options. It is the new wave. It is a glimpse into the future. And by the way, technology stocks have made huge returns over the last five years, so now is the time to get in.” It seemed like good logic. It was hard to argue with. This new brand of investing seemed to offer all of the upside potential with a low probability of loss. It was a genre of high returns with low risk.

It seemed like a “sure thing.”

This new paradigm belief and the allure of high returns with low risk caused investors to forsake true, broad-based diversification in favor of narrowly cast portfolios in one or two asset categories. Another thing that investors were highly encouraged to do was to buy all big blue chip companies. This was the storyline, “Buy all Fortune 500 stocks because these companies are big and stable and their stocks have done so well. You can’t lose.” This was the clear inference that the media and large financial institutions portrayed in the late 1990s into the early 2000s. It seemed to be the proverbial goose that laid the golden egg.

What’s the problem with that?

The problem is that it’s not based in reality. The reality is that any time you narrowly allocate your portfolio into one or two asset categories, you’re setting yourself up for massive losses. If all those stocks had gone up together, guess what? When the market goes down, as markets always do, you can lose massive amounts of your money. And that’s why the American public and the average investor were so decimated in the early 2000s. They had no idea they had loaded up on that much risk. The brokers didn’t tell them. The magazines didn’t tell them. The Wall Street Journal didn’t tell them. The analysts on TV didn’t tell them.

Very few championed the cause of the individual investor.

It was a feeding frenzy of massive proportions. And when it all came crashing down, questions began – “What happened? How could this happen? Isn’t this the new paradigm? What went wrong? We didn’t see this coming. What are we going to do now?”

Many mutual fund companies were also loading up with technology stocks in their mutual funds, and saw massive losses and redemptions in the early part of the 2000s.

But this is not the first time this has happened. This is nothing new. In fact, to an astute investor, it would have been an oddity and a surprise if this did not eventually happen. Why was everybody so stunned and surprised? This is the same thing that happened in the Great Depression. This is the same thing that happened to Japanese stocks through the 80’s. This is the same thing that happened to poor Isaac Newton when he lost all of his money in the South Sea bubble.

The new paradigm is really just the same old story.

This is why a truly knowledgeable investor requires not just an understanding of the nuts and bolts, the X’s and O’s of investing, but also an understanding of the human side, the emotions and instincts, that often sabotage the investing experience. To understand what it really means to be human requires a deep understanding of human history, science, philosophy, emotions, instincts, and human behavior. (You can learn far more about human behavior and investing by reading Don Quixote than you can from the latest copy of Money magazine.) Finally, to be a successful investor requires personal and self-knowledge mixed in with a healthy portion of rigorous honesty.

Trap #7: The “I’ll stop when I get even” reflex

“Is controlling risk important to you?” Most investors will answer “yes” to this question – as it should be. But even though every investor knows risk is important, few indeed, can answer my next question successfully. “Can you show me an academic number, a study, a statistic that shows the amount of risk and volatility in your portfolio? “ When I ask this question I am usually greeted with silence and a deer-caught-in-the-headlights expression. “I didn’t even know you could measure volatility,” is usually the meek reply.

Then, I hit them with the next question. “Well, if you can’t actually measure risk in any meaningful way, is there any way that you can control it? “ And of course, the next answer is a resounding – “NO”.

In many cases where investors are working with a broker or a planner, they have not been provided any meaningful way to compare and contrast the risk inherent in creating and managing differing mixes of assets in their portfolios. Often, investors are blindsided by how much their portfolios drop in down markets. They had no idea that they could lose that much money because they were never shown or given any statistical tool for understanding it. In effect, what people have been told by the brokerage community is that risk is very important.

And yet, frequently they give no meaningful way to actually quantify and identify what risk is acceptable to them.

What this often leads to are big losses in their portfolios. Having suffered the penalty, maybe their portfolios are down one hundred thousand, or two, three, maybe even millions. There is a prudent academically meaningful way to measure volatility. It is called standard deviation and prudent investors are wise to know what it is.

Emotionally, these losses are difficult to own up to.

I have even observed investors who have lost large sums of money, but vehemently defend their portfolio decisions and deny that they lost money at all. Much like the gambler who returns from Vegas and brags about making money at the blackjack table but “forgets” the losing nights playing craps. As humans, we tend to selectively remember the wins and intellectually deny the losses and give ourselves way more credit than we deserve. Psychologists call this phenomenon hindsight bias and in the field of investing it reigns supreme.

The next question I’ll ask is, “If you took imprudent risk to get where you are today, is this something we need to solve? Is it a problem that needs to be addressed?” 

And then, here comes the seventh trap… ready? “I want to fix the problem, but I’ll stop when I get even. I had a million dollars. It’s down to $500,000 (or $400,000 or $300,000) and when it gets back up to a million, that’s when I’ll stop.”

And you can even hear the compulsion and the obsession in that statement. Very much like a gambler who’s down $10,000 in Vegas, who says he’s going to stop when he gets even.

And then I like to ask the investor the next question:  When is the best time to be a prudent investor?  And the obvious answer is always…NOW!  Contact our office to escape the 7 Deadly Investor Traps and protect your families financial future.  NOW is the time.