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Practice a profession long enough, and you’ll notice behavior patterns that are rife within the profession. Most of us are creatures of habits, and habits can be good or bad. The beauty of good habits is that they benefit you effortlessly. Good habits require no willpower.
Bad habits are another matter. Bad habits harm, and they frequently harm imperceptibly. Bad habits must be perceived before they can be broken and replaced with good habits. That demands both attention and willpower.
Within the investing profession, I’ve identified five bad habits that occur most frequently. If you practice any of these investing habits, break them ASAP. If you don’t, be sure avoid them.
1. Chasing Last Year’s Winners
What worked yesterday is guaranteed to work tomorrow, and forever thereafter. That’s simply untrue.
Change is constant. Investors continually cycle out of one investment class and into another. Many investors jump into the hot investment class – the one with the best past performance – just as that class is set to cool.
Data from the St. Louis Federal Reserve show that chasing hot stocks imparts real damage. From 2000 through 2012, the return-chasing investors in mutual funds realized a 3.6% return. The buy-and-hold investor, on the other hand, realized a 5.6% return.
Investors need to remember that stocks are mean-reverting investments: Stocks that are in the stratosphere eventually return to earth. Stocks that have cratered eventually climb out of their hole. Focus on how the future can change, not how the present will extrapolate.
2. Misunderstanding Performance Information
We’ve all seen the advertisement: “Our fund has beaten the S&P 500 over the past five years.” Of course, when you parse the fine print, you find: “Past returns are no guarantee of future performance.”
If someone has outperformed the broad market over the past five years, he’s just as likely (if not more likely) to underperform over the next five years. Investment styles cycle up and down, and that includes the style of income investing. There will be times when investing for income is in favor, and there will be times when it’s out of favor.
Over time, though, income investing works. Investing for income and dividend growth has been proven to generate significant wealth over the years. Look no further than dividend aristocrats like McDonald’s (NYSE: MCD), Procter & Gamble (NYSE: PG) and Altria Group (NYSE: MO).
3. Trading Excessively
Many investors are obsessed with action, but they fail to account for the expenses action imposes. Traders incur higher commission costs and higher taxes compared to buy-and-hold investors.
Even those rare few who win enough to cover the higher costs are unlikely to win continually.
An influential study published in 2000 showed that individual investors paid a steep performance penalty for actively trading. The study focused on 66,465 households with accounts at a large discount broker during 1991 to 1996. Those who traded most earned an annual return 6.5% less than the overall market during the period.
4. Thinking Investing Is Easy
It’s easy to buy and sell stocks. But because buying and selling is easy doesn’t mean making money is easy. Stocks have a very high noise-to-signal ratio. Meaningful information is conjoined with a lot of nonsense. Analyzing stocks requires work. Investing is a business, not a hobby. We are competing against a slew of other investors, many of whom are very smart.
Therefore, it’s helpful to think of investing as having characteristics of a professional poker table. You need to know more than the basics in order to succeed. Yes, you will win a few hands out of luck, which will keep you coming back, but the odds will eventually work against you in the long term.
Don’t allow yourself to underestimate the difficulty. By taking a measured, disciplined, businesslike approach, you can minimize the gambling aspects of investing and increase your chances of long-term success.
5. Obsessing Over Your Portfolio
The Internet gives investors easy access to a constant stream of information about their portfolio. That can be a problem, especially when emotions run high. Many investors check their portfolio several times a day, fretting over the latest share price shift or market panic.
Nassim Taleb offers an insightful example of the pitfalls of continual monitoring in the book “Fooled by Randomness.” Taleb’s example centers on an outstanding investor who earns 15% returns annually on a portfolio with 10% price volatility. This means that in one year the investor has a 93% probability of success.
If the investor only monitored his portfolio annually, there is a 93% chance he’ll experience pleasure.
But the more he monitors, the more likely he’ll confront negative information. The outstanding investor in Taleb’s example actually has a 46% probability that he’ll run across negative information (and thus pain) if he monitors his portfolio daily. And remember, the negative registers twice as much as the positive on the brain.
So, if you’re looking for a New Year’s resolution, resolving to break any of these investing habits wouldn’t be a bad place to start.
Just sit back and watch it grow…and grow…and grow
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