A nice article in Money magazine for the typical investor recently came out by Burton Malkiel and Charles Ellis to remind us of common pitfalls that individuals tend to make. Malkiel is an economics professor at Princeton and author of A Random Walk Down Wall Street, while Ellis authored Winning the Loser's Game.
Here are the six mistakes they outline that I think are significant enough to repeat:
1.) Overconfidence - People tend to think they can out-smart other investors and beat the market. But invariably the results show otherwise, and the psychological factors at play often actually prove counterproductive as we tend to buy high and sell low when things aren't going so well. Staying the course with a solid portfolio and asset allocation, and perhaps even signing an agreement with yourself that you won't deviate from your plan, is the best option.
2.) Following the Herd - Investors tend to think of what's "hot" now and pour their assets into it after much of the population has done so. This feeds a bubble, such as Internet stocks in the late 1990s and real estate in 2008, and rarely turns out well. Furthermore, just doing what millions of others have already done again ensures that you'll buy after the movement. The upward movement is over and you lost your chance. As Warren Buffet has said, "Be fearful when others are greedy, and be greedy when others are fearful." That is, it is to your benefit to go against the herd. When everybody was dumping stocks in late 2008, that was the time to pick them up, and you would have been rewarded handsomely for doing so.
3.) Timing the Market - I dedicated a fairly long post to exploring a common market timing strategy and timing based on "when you think is best" is the worst and most common form of market timing out there. Behavioral psychology dictates that we are poor barometers of where the market is going to go next, and we tend to buy when we've been burned (i.e. there's been a correction) and hold on when we're doing very well (i.e. there's been a huge upswing). In actuality, you want to do the opposite. However, even if you realize this fact, it's impossible to know when the market is going to change courses, so your best bet is to hold constantly. Furthermore, constant buying and selling increases commission costs, taxes, fees, and perhaps some opportunity time will be lost. And you're spending way too much time on your investments for your own good. There's a reason that 95% of actively managed index funds can't beat the market averages over a 10-year span, and these are professionals. Do you really think you can do any better?
4.) Assuming more control than you have - There is not stock market pattern to ascertain and the daily, weekly, and even monthly results of Mr. Market (as Benjamin Graham called it) is completely random.
5.) Paying too much in fees - This is one factor that I constantly emphasize and it is the key to maximizing returns in a way that you can control. Funds with low fees (typically 0.30% or lower) outperform those with high ones almost overwhelmingly. It's hard to make up for that with great picks - and as they say, those funds that have done so in the past are unlikely to do so in the future (past performance doesn't guarantee future results). Another advantage of low-cost index funds is that they're typically more tax-efficient since they're low turnover compared to actively managed ones. So, not only is your return most likely higher, but Uncle Sam takes a smaller portion of your profit.
6.) Trusting stockbrokers - Your broker isn't your friend. He's there to make money for himself. (Sidenote: If you have a financial adviser, make sure he is hourly/fee-based and not on commission. Those on commission tend to try to sell you investments that you don't want.) And your friends, while they mean well, don't know what's going to happen next in the market (nobody does). Going from stock tip to tip simply increases your commissions, adds to your tax bill, and typically ends up performing worse than if you had chosen a reasonable low-cost diversified index fund approach and stayed the course.
These pieces of advice from two very knowledgeable individuals cannot be repeated too many times. Most individuals think that they can easily out-smart the market, time it well, get in when a sector is hot, and trust others for stock picks. None of these typically end well.