Are you making costly mistakes?

It can be tempting to invest without the support of a financial adviser, but there is the possibility of choosing poor investments, trading too often and being overly influenced by the media. The good news is that these costly mistakes can potentially be avoided.

According to research [1], individuals are generally pretty poor at investing. The major observation is that, while there is a wide variation of performance levels, individual investors overall tend to achieve lower returns than their professional counterparts.

So, let’s look at some of the major causes for poor performance by individual investors.

Too much buying and selling

The research states that individual investors tend to chop and change their investments more frequently than professional investors. In fact, they change about 75% of their whole portfolio each year. Put another way, this means their entire portfolio has been changed or “turned over” every 16 months. The research goes on to show that the more often an individual investor buys and sells stocks, the lower the returns tend to be.

Transaction costs reduce profits

Closely linked to the previous point is the costs incurred from trading. Every time an investor buys or sells an asset (type of investment, for example, bonds, shares or property), they incur a cost. Inevitably, the more trades the higher the trading costs and this reduces profits.

What’s more, the difference between the prices at which investors buy and the sell investments (known as the ‘spread’) can act as a further cost. For example, if you want to buy shares in Widgets Inc. you might pay £1.03, but if you want to sell stocks that you own in Widgets Inc, you might be offered just £0.97.

Therefore, as soon as you buy an investment, not only do you pay a brokerage fee for executing the transaction, but you also potentially lose value on the asset that you’ve bought.

Professional investors make huge numbers of high value trades every year and because of their size, they can negotiate better terms from the dealers. In practical terms this means a narrower spread and lower transaction fees. This means that individuals are at a trading disadvantage.

Poor selection due to being swayed by the media

Even allowing for trading too often or paying relatively high trading costs, individual investors tend to be less successful at picking stocks (shares in a company) than professionals. One of the reasons for this relatively poor selection is the tendency to be swayed by the press. Individual investors tend to buy shares in companies that are in the news more often than they sell them, irrespective of the companies’ prospects.

Rather than conducting in-depth research in a stock, individual investors can place too much faith in what the media are saying about a company. This lack of research is called ‘speculative investing’. In the short term, this increased demand for a company’s shares will likely push the price up, but this is soon undermined by the fundamental realities of the company’s future which can send the price of its shares down.

Chasing the action

of the reasons that individuals are influenced by the media is the relative lack of time or resource they can devote to research. This can lead to individual investors not giving enough attention to important information and devoting too much attention and acting on old or irrelevant information.

Repeating past behaviour

When investors do get it right, there can be a tendency to repeat past behaviour for the wrong reasons. The research suggests that investors are more likely to repurchase a stock that they previously sold for a profit than one previously sold for a loss.

The correct approach would be to appraise each stock on its merits at any given time, disregarding what success or failure the investor might have experienced with that stock before. As we are frequently reminded, past performance is not a reliable indicator of future results.

Following upward momentum

This emotional connection to past performance also manifests itself in the pursuit of stocks that have already risen in value and are far less likely to buy a stock whose share price has been falling. A rising stock isn’t necessarily a bad thing to invest in provided the research and analysis point to continued gains, although performance is never guaranteed.

Unfortunately, individual investors don’t always do this homework. The research led to the belief that individual investors tend to buy stocks because of what they hope will happen and sell stocks because of what has already happened.

This leads to the conclusion of the research that many investors assume the recent past is indicative of what is to come.

It isn't.

Selling winners and keeping losers

The research also suggests that people are much more likely to sell investments that have risen in value while keeping those that have fallen in value. This has two potential problems.

Firstly, investments that are doing well might have more growth to deliver, while those that are falling might be hung on to for too long. The net result can be to bring the overall value of the portfolio down.

Secondly, when an asset that has grown in value is sold, it can attract capital gains tax, reducing net profits. Selling the losers could offset some of these gains, reducing the potential tax. By selling only the winners, an individual investor might be creating an unnecessary tax bill.

Individuals might be creating an unnecessary tax bill.

Read more:How to reduce your Capital Gains Tax liability

Lack of diversification

Individuals tend to prefer local and familiar stocks. Once again, too much emotion and too little research could drive decision making. To achieve a diversified portfolio, we believe in investing across a range of asset classes. This could help to spread risk with the aim of lessening the potential for loss of value and increasing the potential for growth and income.

Read more:The importance of diversification

How could you avoid these costly mistakes?

Successful investing might be simple, but it isn’t necessarily easy. However, the mistakes that individual investors most commonly make could potentially be largely avoided if you:

Do the research. Examine the assets that you are considering buying or selling and make sure that the research is driving your decisions rather than emotions or the media.

Diversify appropriately. Avoid creating a portfolio that carries too much risk or vulnerability to changes in the fortunes of a narrow range of investments.

Be patient. Don’t trade too often. Accept that there will be some short-term turbulence in asset prices.

Getting these decisions right is not easy and will depend on individual circumstances. The research alone can be daunting. Knowing when to hold and when to ditch a loser is always open to debate. So rather than attempting to invest alone, you could get guidance or advice from a professional.

According to the research conducted by “The behaviour of individual investors”, Barber and Odean, University of California, 2013, to which this document repeatedly refers, institutional investors incur lower costs, make better decisions and are less corrupted by emotional distractions.

Sources:

[1] “The behaviour of individual investors”, Barber and Odean, University of California, 2013