Investors: Are you your own worst enemy?

Some investing mistakes to avoid.

By AARON KATSMAN
June 17, 2010 03:16
3 minute read.
Investors: Are you your own worst enemy?

Aaron Katsman 88. (photo credit: )

With so much information available on the Internet and around-the clock business TV, the rallying cry from these media sources has been for investors to manage their own funds.

Investing is easy, they say. Not to mention that if you pay very low fees, you can trade and trade and make lots of money.

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Well, if that is the case, why does study after study point to the fact that do-it-yourself investors continue to under-perform the markets? What mistakes do individual investors commonly make, and what can they do to prevent them?

INSIDE INFORMATION

Many individual investors believe that when they read an article about a particular company, they now possess information that is not widely known. They forget that the only reason they read about it is because it is now public. Princeton’s Burton Malkiel has argued that markets are “efficient.” This means that all relevant information pertaining to a specific company is reflected in the company’s stock price. From this perspective, attempting to outperform the market is futile.

If this was entirely the case, then a stock’s price should never move, unless there is new news on the company. But in reality we see stock prices move day to day without any news coming out. Why? Because it’s not necessarily important that all the information is public. What is important is how investors continue to reevaluate their analysis of the news.

It may be that the reason individual investors continue to under-perform is because the system favors large institutional investors and not regular Joes. According to Terrance Odean, a finance professor at the University of California Berkeley: “Even when the little guy thinks he’s in the know, he is often clueless about what’s going on behind the scenes. Not so the big guys.... For an individual to not believe that he’s at an informational disadvantage when he’s trading against guys from Goldman Sachs is naive. It’s like deciding to play one-on-one with a professional basketball player. You’re going to lose.”



HERD MENTALITY

Another mistake investors make is that they tend to buy the same stocks that everyone is buying. This can create a situation of buying once the stock has already moved up aggressively. The goal for an investor is to buy low and sell high – not the other way around.

Forbes recently reported about a 2006 study in which Odean found that “like children fighting over the same toy, investors are often attracted to stocks because others want them. In fact, individuals are much more likely to buy and sell the 10 percent of stocks mentioned in the news and ignore the other 90%.

“The problem with buying stocks when they’re popular rather than on the basis of fundamental value is that they tend to be expensive and susceptible to changes in investor sentiment. The day after a stock ranks among top performers, twothirds of all trades by individual investors are buys (institutions, by contrast, tend to wait for dips in prices and trading volume). Over the following month these hot issues underperform the overall market by an average 1.6 percentage points.”

OVER-TRADING

A third mistake investors tend to make is that they trade way too much. It’s very difficult to always be right when trading stocks actively. In fact, if you trade too much, instead of investing in a company, you are basically gambling as to which direction a stock will move. I can’t tell you how many people have told me that they trade “just to make a hundred dollars a day.”

Inevitably, after about two weeks, they give up on that strategy. Why? Because it’s not successful for the overwhelming majority of individuals. If it really was so easy to make that kind of money every day, don’t you think everyone would do it? Investors need to remember that there are no shortcuts. There is virtually no way to get rich quick in investing. Using an investment professional can help you stay focused and disciplined with your investment portfolio and help you build wealth for the long term.

aaron@lighthousecapital.co.il
Aaron Katsman, a licensed financial adviser in Israel and the United States, helps people who open investment accounts in the US.


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