July 9, 2009

Re: Common Investor Mistakes

 

As part of my continuing series, I thought it would be useful to address the common mistakes investors make.  Not surprisingly, I have encountered the examples discussed below on a regular basis, some of which I have been guilty during my evolution as a wealth manager.  That said, successful investment planning is a continuous process that is enhanced through proactive review and regular feedback. 

 

The feedback loop is defined by assessing results versus expectations.  In addition to measurement against certain indices, an investor should first define his or her required return.  This should not be an arbitrary percentage, but one that is necessary to fulfill one’s financial objectives.

 

1)      Not gauging one’s required return – Most investors may subjectively classify themselves as “aggressive” or “conservative”.  However, what I have found to be more universally true is that most investors disdain significant loss, regardless of how they classify themselves.  The major difference between an allegedly “aggressive” investor versus one more conservative is his/her level of confidence.  Unfortunately, those who claim to be more aggressive have less reason for being so.  It’s all a matter of experience.  The more experience one has investing, the more one realizes that market knowledge is an imperfect science.

 

Gauging one’s required return can help the investor establish more realistic expectations to guide one’s decision making.  The prevailing question then becomes, what level of risk must be assumed to accomplish expected performance?  The complimentary consideration is to develop sound techniques to approach that expected return with least risk.  That way, one is more likely to achieve his/her objectives.

 

2)      Investing too conservatively – On the other hand, it is more common that I find investors who are so risk adverse that they are unwilling to consider investment alternatives and techniques that would otherwise help to reduce risk.  The primary roadblock for these investors is their pre-conceived notion of what risk is.  The majority of people perceive risk as a loss of value on their statement.  This is the most obvious example, but represents merely one type of risk which is usually momentary, and often deceiving.  In fact, there are many dimensions of risk investors should defend against.

 

3)      Failure to understand the primary sources of investment risk:

 

a.       Purchasing Power Risk – When one accepts an inferior return so that assets will not fluctuate in value, greater risk may exist in that inflation will erode the purchasing power of these investments over time.   Instruments such as savings accounts, money market funds, and CDs may preserve principal momentarily, but they are usually inappropriate vehicles for a long range investment plan.   

 

b.      Interest rate risk – Bonds, that is obligations issued by corporations and national or local governments, usually offer greater yields than banking deposits whose denominations are backed by the credit rating or specific assets of the issuing entity.  Bonds are relatively secure in that the amounts borrowed are scheduled to be repaid at a specific maturity date, usually with semi-annual interest payments in between.  Bond yields will vary according to the credit rating of the issuer.  Bonds denominated in other currencies may also offset the value of the dollar (see currency risk).  But the primary risk with bonds is interest rate risk.  There exists an inverse relationship between bond values and interest rates generally.  For instance, a 10 year Treasury Note issued late last year with less than a 3% coupon (interest rate) might trade at less than par value from an oversupply of Treasury bonds necessary to finance the budgetary deficit.  That means interest rates are likely to rise on new issues and reduce the value of outstanding bonds paying lower than market rates.  This phenomenon is likely to affect interest rates on other loans also, including mortgages, also the rate on which other bonds must be offered.  The value of U.S. bonds which have already been issued and remain outstanding will also be devalued to bring their yields to parity with the market rate.  On a broader basis, interest rate risk is a natural response to inflationary pressures which increase the cost of borrowing and force a contraction of the money supply.  When the economy is already in a recession, artificially propped by deficit spending, interest rate increases prolong the agony, otherwise, higher taxes are necessary to reduce ongoing deficits and restore confidence in the dollar.  Welcome to Obamanomics.

 

The solace that remains for bondholders (pending no credit deterioration) is they should receive a full return of their principal with cumulative interest income that should exceed bank deposits.  As we have seen however, bonds do not protect well against inflation, but may be used more commonly as a risk reduction technique against investments with greater volatility, especially stocks and commodities.  The smartest bonds strategies to consider during periods of imminent inflation are to keep maturities short so that proceeds may be continually re-invested at higher rates or in other instruments that keep better pace with inflation.  Also, consider those issues which already trade at relative discount to their face amount, either due to a reduced credit rating, or because they have been issued at lower interest rates.  The total return of a bond from its interest payments and appreciation to par value is referred to as “yield to maturity”. 

 

c.       Company Specific Risk – In the case of bonds, company specific risk is more commonly referred to as default risk, when interest payments and repayment of principal may not be made in a timely manner if the issuer’s financial condition suffers because of the economy or poor operating performance.  In that event, the bond is said to have defaulted if it breaks its covenant, a written agreement that defines the terms of repayment and/or operating requirements which may be necessary to provide creditors with further confidence in the terms.  If a bond defaults, creditors may work with the issuer to renegotiate the terms of the note or more often file legal claims for immediate payment, including the possibility for liquidation of assets or bankruptcy declared by the issuer.

 

Bonds with lower credit ratings carry more default risk as a consequence of higher debt ratios or less consistent earnings typical to a newly formed company or certain industries that require more expensive investment in tangible assets and equipment.  However, bonds with lower credit ratings do offer higher yields, and to enhance their appeal, the issuer may also attach warrants for the future purchase of stock at a pre-set price, or offer the privilege to convert each bond to a specific number of shares of common stock.  Such enticements make these bonds more marketable, enabling the company to attract the necessary capital at potentially lower yields, but usually still at higher rates than investment grade debt. 

 

In the case of stocks, company risk affects the entity’s ability to reach expected earnings targets with overall operating performance or changes to the economy which may affect company business.  While the interests of stockholders are subordinated to bondholders in the event of re-organization, bankruptcy, or liquidation, shareholders might receive more favorable performance in the event a company meets or exceeds its earnings expectations over time.  However, superior stock performance might also be more difficult to achieve during a challenging economy.

 

In some cases, an entire industry may be more highly impaired than the economy in general if adverse conditions are more prevalent within it.  Currently, the financial industry (banking, investment banking, and insurance) may be the most evident example, but other industries that are credit sensitive, such as real estate, construction, and automobile manufacturing are following in lockstep.  Furthermore, increased government regulation can momentarily decimate near term profit expectations before an industry is able to accommodate those demands.  For instance, health care (pharmaceuticals, biotechnology, health care networks and insurance providers) and electric utilities may find their operating environments further constrained by the prospect of national health care and “cap and trade”.

 

d.      Market risk – It has been said that if an investor owns a sufficient number of stocks and bonds within a portfolio, either individually or through mutual funds, then the investor has achieved optimal diversification, where the risk of owning any specific stock or bonds has been minimized.  Not necessarily so.  Besides stocks and bonds, there are many categories of assets and as many markets that trade of them.  Therefore, market risk refers to the risk inherent in any market throughout a range of economic events. 

 

Other than the supermarket, when people think of the term “market”, they usually envision the stock market (usually measured by the S&P 500 Index or Dow Jones Industrial Average) as the prevailing barometer of financial activity, but there are many markets – physical and over the counter, domestic and international, over which seemingly unlimited number of securities trade, including bond markets, the real estate market, the options market, futures market, commodities market, and subcomponents of those markets, such as the market for municipal bonds, Treasury bonds, corporate bonds, junk bonds, precious metals, industrial metals, agricultural futures, currency futures, interest rate futures, etc.

 

True diversification occurs across a number of markets.  Many investors may be limited by their lack of understanding or appreciation for non-traditional investment approaches that may help better diversify risk, categories and techniques which include international bonds, emerging markets debt and equity, currency arbitrage, real estate investment trusts (REITs), private equity, puts and calls, equity collars, bear market funds, precious metals, industrial metals, i.e., those assets more likely to offset the risk of traditional investments during a more challenging environment.

 

For instance, currency risk is a type of market risk which refers to the value of assets denominated in one currency versus another.   The risk of dollar devaluation relative to other currencies may be reduced by holding international investments not traded as ADRs (American Depository Receipts) or hedged to the dollar.  Another form of currency arbitrage is known as “carry trade”, which involves purchasing currency futures at higher yields while selling or borrowing lower yielding currencies.  Currency yield is inversely related to currency supply and therefore near term currency price.   

 

e.       Systemic risk – Systemic risk is triggered by pervasive economic events which happen infrequently but affect all markets as a whole.  The recent “financial crisis” is an example of systemic risk, so was the Great Depression.  Systemic risk cannot be diversified away, but is corrected once markets resume equilibrium, which may require more intense government intervention, increased regulation, and market reforms.  Yet government intervention may only be as effective as the credibility of monetary policy, if not diminished by the attendant bureaucracy which stagnate economic activity.

 

4)      Given the multitude of risks which investors face, not understanding the underlying economic dynamics which influence investment risk and performance – Many investors may base their decisions on less reliable criteria including past performance and their familiarity with what has worked well (or didn’t work so well) in the past.  However, past performance is not indicative of future results.   What drives future market results will largely depend on which sectors become most vital to the global economy.  For instance, it would be unwise to assume that because the United States has been the most dominant economic force over the past several decades that the same trend will continue.   China and India compose 40% of the world’s population, and as the United States and Western Europe outsource more of their labor and manufacturing across the globe, newly developing economies will require raw materials and natural resources to raise their infrastructures consistent with those growth expectations.  Since commodities are pegged to the dollar, increased energy consumption and demand for raw materials abroad could easily trigger global inflation.  The presence of inflation despite slower economic activity is known as “stagflation”, an economic phenomenon similar to what occurred during the 1970s.  Given the present trajectory, it appears we might be headed for a rerun.

 

5)      Failure to sufficiently diversify a portfolio from the number of random and particular investment risks that are likely to be encountered - Since past performance is not indicative of future results, and because the future might become less predictable than present expectations, asset allocation is the primary investment strategy which helps neutralize as many portfolio risks as possible while providing the investor an optimal chance for achieving his/her required return.  Asset allocation* does not guarantee specific investment performance, but it can help to identify a more ideal combination of investment categories and strategies whose risks offset each other over time.  In fact, studies have shown that asset allocation is responsible for 91.5% of portfolio returns.  Combining asset allocation as a primary discipline with emphasis of certain investment techniques and asset categories based on the prevailing economic condition is known as tactical asset allocation.  Dovetailing these strategies provides the investor with a more vigorous overall approach.   


*Asset Allocation does not guarantee against loss.  It is a method used to help manage investment risk. 


6)
     
Failure to consider the relative pros and cons of an investment approach dispassionately, and without bias - Pre-conceived notions about an investment may prevent one from considering its merits relative to an overall portfolio strategy.  Investors frequently misunderstand that risk occurs in not one but two dimensions – amplitude and direction.  Therefore, when properly designed, the composite risk of a portfolio is not merely the weighted sum of its risk categories, but may be less than the weighted sum of its risk categories when the risks offset one another.  For instance, a stronger correlation exists between domestic stocks and domestic bonds than between traditional stocks and precious metals, and even less correlation occurs between domestic bonds and precious metals.  Therefore, a portfolio which includes some combination of domestic stocks, domestic bonds, and precious metals is typically less risky than one which includes only domestic stocks and bonds, even though precious metals may be the riskiest investment category (in terms of amplitude) among the three.  Precious metals are less directionally correlated with domestic stocks and often may be negatively correlated with domestic bonds.  Because precious metals move somewhat in opposition to stocks and bonds, this asset category can reduce the risk of a traditional portfolio.  As an inflation sensitive investment, real estate exerts a similar risk reduction effect, and with dividend income paid from rents, provides further opportunity for a more consistent total return.

 

The risk of owning individual stocks can also be reduced with options, what most people consider to be an even riskier investment.  Any investment can be risky when not fully understood.  Since many investors have a more familiar comfort level with basic investments such as the mutual funds within their 401(K), some investors may not be as receptive to consider techniques which may be outside their range of availability or understanding.  A better precaution would be to become more familiar with the scope of investment strategies which compliment one another more effectively within a portfolio.   That’s why it’s useful to consider a variety of strategies within your portfolio, no matter what your perceived “risk tolerance” may be, especially when economic circumstances become more challenging and less predictable.

 

7)      Timing the market – While it may be wise to invest more favorably along global macro economic trends, the ability to accurately determine the proper entry and exit strategy for a specific asset is very tricky business indeed.  Even the most seasoned traders are not able to accurately predict these points any better than a layperson tossing darts on a board.  That is why investors should rely more heavily upon asset allocation as the most predominant investment approach.

 

Investors may become easily distracted by the avalanche of information presented to them about the financial markets on a daily basis.  The majority of this information is merely “noise”, and the more frequently publicized, the less reliable it normally is.  Here is a better rule of thumb related to the financial markets– whenever in doubt, watch what everyone else does, take careful notes as necessary….then do exactly the opposite.   

 

Rather than listen to the nightly news, I more highly recommend subscribing to quality periodicals such as the Wall St. Journal, Barron’s, and Forbes, whether on paper or on-line.  I have found these publications to provide a rather insightful perspective on how the prevailing political and economic climate may impact the financial markets, not to mention the ability to reference opinions from the most well respected traders, fund managers, CEOs, and venture capitalists, both here and abroad.  To become an astute investor, one must seek to appreciate the evolving dynamics of capitalism, thereby enabling one to adjust more effectively with the circumstances at hand.

 

8)      Failing to revise an investment strategy based on differential performances within the  portfolio, based on changes in the economy, or due to changes in personal financial situation – The most common critiques I have for some investors include their failure to revise their investment approach with changes to the economy, failure to periodically re-optimize their portfolio for an appropriate allocation against performance drift, and most importantly, failure to reconsider their investment approach when major changes occur to their financial situation.  Since the majority of investors may become overwhelmed by their day to day responsibilities, and the minutia that often comes along with it, they may fail to consider the bigger picture as it relates to their overall financial success.  The most important secret to financial success is prioritizing tasks.  When certain tasks become more tedious or time consuming, it often pays to delegate those priorities for which one may have less time, patience, or expertise.  That way, one can focus on their core competencies, and other aspects of their lifestyle that might be most important to them.  For instance, a well experienced financial advisor can accelerate your learning curve by providing well rounded advice that is most conducive to your needs, while helping you to avoid the more common mistakes that time and convenience does not permit.  At the very least, you will have a valuable resource at your disposal and someone who clearly has a vested interest in your financial well being.

 

Unfortunately, an investor cannot reasonably expect to implement an investment plan and keep it the same way indefinitely.  As we have seen, the financial markets don’t behave themselves so well at all times.  Therefore, an intelligent investor shouldn’t consider their portfolio like a Chia Pet.  Life would be a lot easier that way, but successful portfolio management requires one to review their investment strategy periodically and trim the weeds as it becomes necessary. 

 

9)      Letting the tail wag the dog – Another significant culprit that diminishes investor success is the emphasis of fee avoidance versus potential merits of any investment approach, including working with a professional advisor.  Every investment decision has its cost, whether measured by time, experience, quality of research, spectrum of choice, or absolute cost.             

                  

If considering to work with a financial professional for any number of reasons, consider his or her fiduciary credentials, years of experience, areas of expertise, common clients, how compensated, and to find out more, how you might be properly introduced.   Many employees have access to financial representatives provided by their employer’s retirement plan administrator, those who work for salary through large financial institutions and claim to provide their services for “free”.  Nothing is free.  The consumer simply receives what is paid for.  Compare the credentials and continuity of service available with someone who operates their own financial planning practice, with direct access to all the largest financial institutions, and one might find themselves pleasantly surprised by the upgrade.  Not only might one receive far superior service, but the cost might be more reasonable than expected too.

 

When it comes to something as important as your financial well being, wouldn’t you prefer working with someone who has devoted considerable time and resources to his/her craft?  I’m sure that you visit your doctor and consult with your accountant and/or attorney on a regular basis for the same reason.

 

There are many investors who have mastered numerous techniques over a number of years through trial, error, and research who are rather capable money managers.  Hiring a money manager of your own is not for everyone, but will depend upon one’s financial dedication and the time willing to spend achieving those skills.  Those who are financially conscientious face a choice – how do you prefer achieving financial success?  The path to financial success sometimes involves a bumpy road, fraught with potential mistakes that may become pearls of wisdom in retrospect, but what path is right for you? 

 

My firm serves those who pursue financial freedom and a lifestyle dictated by their own terms.   As your consultant, my role is to provide you with quality advice and support that is evident with a well executed plan.

 

Are you ready for the challenge?

 



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