One Dozen Reasons Why the Average Investor Underperforms, Part 2

 

You can catch part 1 here, where the first six reasons were:

  • Arrive at the wrong time
  • Leave at the wrong time
  • Chase the hot sector/industry
  • Ignore Valuations
  • Not think like a businessman, or treat it like a business
  • Not diversify enough

On to the last six reasons:

7) Play around with pseudo-stocks

ETFs are simple. Perhaps they are too simple, allowing people to implement their investment views very rapidly, when have not done sufficient due diligence on the target of their investing.

As a quick example, consider the CurrencyShares series of ETFs. You know that if you use these, you are making an unsecured loan to JP Morgan, right? Well, you might be bright, but most people think these funds are collateralized.

ETFs are complex, particularly if you use any that are short or levered. They attempt to mirror the price move of a day, and typically underperform if held over longer periods. Again, you might know this, but most people don’t. Personally, I would ban them on public policy grounds.

Commodity ETFs and Bond ETFs have their own issues, as do ETNs with their credit risk, etc., etc. How many people actually look through the prospectus, or at least the information sheet provided by the fund? Precious few, I think.

If you use ETFs, stick to the good ones. (Article one, Article two)

8) Gamble

This one should be obvious. Most good investing focuses on avoiding losses, and compounding gains in a predictable manner. Taking chances, like speculating on the short-term direction of markets through puts and calls is a way to lose money predictably. (I leave out covered calls and married puts.) It is hard enough to get a good idea of where a stock is going in the long run. Getting it in the short run is much harder.

9) Ignore Balance Sheets and Cash Flow

Those who follow the fundamentals of most companies pay attention to the most manipulated of the three main financial statements — the income statement. Companies often try to make their earnings numbers, and compromise their accounting in the process.

Accrual entries depend on assumptions and can be tweaked to favor management’s view of profitability. Cash for the most part is a lot harder to fake, and most companies wouldn’t consider faking it, because few look there.

Looking at the change in net worth per share with dividends added back is often a better measure of financial progress than earnings per share. Beyond that, investing is not just about earnings, but about the margin of safety in the company. Many things look very cheap that have a significant risk of failure. Analyzing the balance sheet can keep you from many situations that will result in losses.

10) Try a little of this and a little of that – No strategy / No edge

It takes a while to become good at a method of investing. Read about different methods and settle on one that fits the whole of your life. I gave up on certain methods because they took up too much time, and I had a family to tend to.

I rarely short assets, because to do it right would require large changes to the way I do risk control. (The same applies to options.) Good risk control is easy when the choice is between long assets and cash only. It gets a lot harder when you can short or go leveraged long, because you no longer have full control over what you are doing — the margin clerks will have some say over your assets.

Also, understand your circle of competence. What is your edge, and where does it apply? I avoid investing in biotechnology because I can’t tell a good idea from a bad one there, aside from estimating how long the company has before it needs to raise more capital. I do more with insurance than most do, because I intuitively understand how the companies work, and what a good insurance management team is like.

That doesn’t mean you can’t broaden your strategy or increase your circle of competence. But it does mean that you will have to study if you want to do it well. This is a business if you are going to make active bets in a big way. You will need to spend time equivalent or greater than that of a significant hobby.

11) Trade Aggressively

In general, you don’t make money when you trade. You make it while you wait. Most ideas in investing take time to work out, unless you are gambling on a short-term event, or speculating on a move in the stock price.

Most of the studies that I have done on investment in mutual funds of all sorts, including ETFs, show that buy-and-hold investors typically do better than the average investors in the mutual funds. On average, the losers are the ones who do the trading. That’s not to say there aren’t some clever traders out there. There are, but you are not likely to be one of them. Frequent trading, unless carefully controlled, is more likely to result in a lot of losses, and few gains, because fear causes many to panic in the short-run.

Even if successful, most aggressive traders get taxed more heavily than those with long-term gains. Most of my investment income qualifies for the lowest tax rates, and since I use big gains for charitable giving, my effective rates are lower still.

12) Short incautiously

This may affect the fewest number of my readers, but I have seen even professionals struggle with making money from shorting, particularly when they think an asset is worth nothing ultimately.

Shorting is a difficult way to make money, because your downside is unlimited, and your upside is limited to 100% if the asset goes to zero. Another way to say it is that your risk gets larger with shorting as the position moves against you. The risk gets smaller when long positions move against you.

if you must short, then treat it like a business and do it tactically.

  • Diversify shorts much more than longs.
  • Be tactical, and go for lots of little wins rather than a few big wins.
  • Set a time limit on your short positions at inception, and close out the positions no later than that.
  • Be aware that you are likely embedding factor bets on steroids, which can blow up in the wrong market environment. (E.g., short size, long value, short quality, short liquidity, short momentum, etc., would be common for a value oriented hedge fund)

Conclusion

Be aware of the foibles that exist in investing. There are many of them, as described in this article and the last one. If you want to profit over the long haul, act to avoid the traps that derail most retail investors. If you get knocked out of the game, and no longer invest as a result of a trap, you forgo all of the gains that you might have otherwise gotten with more diligence and patience.