Oran Hall | Following the crowd and other ways investors get it wrong
Even the best investors don’t always get it right. It is human to err indeed.
Investors make many kinds of mistakes, and there are various reasons they do. A common one is focusing on the short term. Although their goals may be long-term, they pay far too much attention to short-term market fluctuations.
Others are impatient because they want quick returns. It is more productive to focus on the long term and pay less attention to short-term fluctuations as most investments tend to eventually do reasonably well over the long term.
Following the crowd is another mistake investors make. This tendency to do what everybody else is doing may cause them to buy when prices are rising and sell when they are falling, sometimes buying at inflated prices, or selling at discounted prices thus missing the opportunity to gain when the market changes direction. Often, the opposite is what they should do.
Sometimes investors change investments too often. This may cause them to miss out on long-term gains, and to incur more expenses because of the cost of each transaction.
Some investors do not appreciate that volatility is an inherent element of investing. Prices rise and fall and actual returns vary from the expected regularly; risk is a common feature of investing. Thus, it is not very productive to panic and liquidate investments when the returns are not as expected.
There are times when investors are too quick to act on the information available to them. Such information may not necessarily be the only material information available. A better approach is to check on the accuracy and value of the information and to determine if there is more useful information.
Not so long ago, a member of a group I was a part of was strongly recommending that the group invest in a particular stock because he had bought it four years previously and it had done well during that time.
Past performance may be a good indicator of future performance, but it does not guarantee it. Before taking action, the investor is best advised to do the required research to determine the wisdom of such a course.
Better to diversify
It is not unusual for investors to put a disproportionate share of their resources into one or a few investment instruments. This focus on concentration may yield significant returns if the markets move well and in the right direction but may be catastrophic if the markets move unfavourably.
It is better to diversify as it reduces portfolio risk and promises a greater level of certainty in getting positive returns, considering that different instruments react differently to the same event.
Some investors err by having a fixation on safety; they avoid instruments that are generally more risky and, in trying to secure their principal, surrender the opportunity to earn higher returns. The truth is, there is no instrument that is entirely risk-free.
Although bonds, for example, generally deliver to the investor the nominal sum invested if held to maturity, they offer no protection against purchasing power risk as the ability of the principal sum to purchase the same basket of goods and services at maturity as it was able to purchase at the time of the initial investment is virtually non-existent.
It is also worth appreciating that so-called safe investments do not yield high returns: safety and high yields do not go together.
Sentiment is not always good. Investors who allow it to cause them to be wedded to their instruments can do harm to their investment programme. If an investment is not living up to expectations or no longer fits the portfolio, it is best liquidated rather than being lovingly embraced when the sales proceeds could be best used to capitalise on other opportunities.
Rather than focusing on market timing and securities selection, investors could improve the returns of their investments by focusing on a suitable asset allocation strategy consistent with their goals and objectives. Numerous studies have confirmed that asset allocation has a stronger bearing on portfolio performance than securities selection.
Some investors tend to wait for an investment that has lost value to return to its original cost. Although this may indeed happen, it is possible it may not happen. Additionally, by waiting for the time when its price may reach the original level, important opportunities may be missed to liquidate the investment and reinvest the proceeds in more promising instruments.
Investors also err by investing in what they do not know about; investing without doing adequate research; investing on the advice of people who know little about investing and the markets; investing based on the strategies of others; failing to recognise that no investment strategy fits everybody; and investing on the basis of emotional biases such as overconfidence, fear, and greed.
- Oran A. Hall, the principal author of ‘The Handbook of Personal Financial Planning’, offers personal financial planning advice and counsel. firstname.lastname@example.org