We'll start today's column with a quiz. What's the biggest threat to your investment portfolio?
1) Rising interest rates
2) Inflation
3) Slowing global growth
4) You
For many investors, the answer is 4. Benjamin Graham, the legendary value investor, said it best: "The investor's chief problem - and even his worst enemy - is likely to be himself."
Investors sabotage themselves in countless ways. Today we'll discuss some of the most common. How many of these self-defeating behaviours apply to you?
You buy high and sell low
Those returns advertised by mutual fund companies? Turns out most people don't do nearly as well as the numbers suggest. Why? Because, being emotional creatures, they tend to buy at the top when everyone is feeling optimistic. Then they sell at the bottom when they can't stand the pain of watching their investments fall another penny.
This is the opposite of what they should be doing, of course, and it wreaks havoc on their returns. For the 20 years ending Dec. 31., 2010, the S&P 500 gained 9.14 per cent annually, including reinvested dividends. Yet U.S. equity mutual fund investors averaged just 3.83 per cent over the same period, according to a recent report by Dalbar Inc.
Some of that difference is accounted for by fees, but a lot of it has to do with investor behaviour. On average, investors held their funds for just 3.27 years - hardly long enough to enjoy the fruits of a buy-and-hold strategy.
"Failure to retain investments for optimum periods is a major reason that investor returns fall short of the potential," Dalbar, a Boston-based research firm, said in its 2011 Quantitative Analysis of Investor Behaviour.
You trade too much
If you trade frequently, you'll pay more in commissions and taxes. You'll also be more likely to fall victim to the "buy high, sell low" phenomenon.
In a study titled "Trading is Hazardous to Your Wealth," University of California professors Brad Barber and Terrance Odean divided 66,465 U.S. households into five groups based on the level of monthly turnover in their stock portfolios from 1991 to 1996. The highest turnover group earned an average annual return that was 7.2 percentage points lower than the least active group. In a separate paper, the authors found that 80 per cent of day traders in Taiwan lost money over a typical six-month period.
The reason people trade excessively is that they overestimate their own abilities, which is not surprising given that discount broker ads portray trading as something even a baby can do. Men are especially prone to such overconfidence, the authors said.
"Both men and women are lousy traders; men merely trade more frequently," they said.
You are too impatient
Time - not short-term trading skill - is the small investor's best friend. Whether you invest in mutual funds, exchange-traded funds or individual stocks, the secret to building wealth is to let your portfolio grow - preferably including reinvestment of dividends - over many years.
Staying focused on the long term will help you resist common traps that afflict short-term-oriented investors, such as "story stocks," initial public offerings and hot sectors that cool off as soon as you jump in. In many cases, doing nothing is the best strategy of all.
As Warren Buffett said: "Lethargy bordering on sloth remains the cornerstone of our investment style."
You thrive on excitement
Investing is not supposed to be entertaining. Yet with the proliferation of cable business channels and Internet discussion boards, investors face a 24/7 flow of information, analysis and often-contradictory opinions. Absorbing all this information is a full-time hobby for some.
No wonder they feel the need to buy and sell constantly.
"When it comes to investing, we seem to be addicted to information. The whole investment industry is obsessed with learning more and more about less and less," said James Montier, author of The Little Book of Behavioural Investing: How Not to Be Your Own Worst Enemy. "Rarely, if ever, do we stop to consider how much information we actually need to know in order to make a decision."
Investors are better off tuning out the noise and focusing on a handful of attributes they consider crucial when choosing an investment. Mr. Montier, for example, looks at the balance sheet, the valuation and the company's capital allocation record. Another investor might focus on growth of earnings and dividends.
The important thing is to have a focused strategy, instead of "trying to know absolutely everything about everything concerned with the investment."
You let someone else do everything
I'll be blunt: If you blindly trust someone else to manage your money, you are inviting that person to take advantage of you. It happens all the time. The best way to protect yourself is to learn as much as you can about investing. This is true whether you look after your own money or hire someone to do it for you.
There are many honest, hard-working advisers. There are also plenty of sharks who will eagerly exploit many of the self-defeating behaviours discussed above for their own gain. Recognizing these behaviours, and the damage they can inflict on your portfolio, is crucial to becoming a more successful investor.
John Heinzl