When investing, the stakes are alarmingly real: If we screw it up, we lose money.
In his book “The 5 Mistakes Every Investor Makes And How To Avoid Them,” Peter Mallouk outlines some of the most common investor errors he’s seen over the course of his career as a wealth manager.
His firm, Creative Planning Private Wealth Management, manages about $US10 billion for clients across the country, and has been named by CNBC as the top independent wealth management firm in the US.
So it’s safe to say that he knows what he’s talking about.
While he dives into more detail in the book, here’s a quick overview of Mallouk’s five recurring investor mistakes:
1. Basing investments on whether the market will go up or down
People who time the market try and be strategic about investing their money when the market is on the upswing, and pulling it out when the market is taking a bad turn.
The problem with market timing, Mallouk writes, is that it doesn’t work. In fact, he divides the vast majority of market timers into two camps: idiots and liars. He says that liars are people in the financial industry whose paydays come from making predictions — whether or not they’re right — and idiots are the well-meaning investors who remember only their good decisions and triumphs.
The market is volatile, Mallouk explains, but there’s a reason to let your money ride the wave: “The risk of being out is far greater than the risk of being in,” he writes. “Being on the sideline often results in permanently missing the upside. On the other hand, if someone invests today, the worst thing that can happen is temporarily participating in the downside. Big difference.”
2. Constantly trading stocks
Active trading means choosing to buy and sell stocks quickly and regularly, rather than letting your investments lay low and play a long-term game. The idea is that you’ll be so smart about your purchases or sales that you’ll beat the “market return,” or the combined return of stocks listed on exchanges like the NYSE.
Mallouk points out that among people trying to beat the market, there are going to be people who do better and people who do worse: winners and losers. “Here’s the rub though,” he writes. “Trading isn’t free — there is always a cost.” He explains that, like in a Vegas casino, the house always wins. In this case, the house is the brokerage.
Because the house always wins, the “winners” in this scenario aren’t doing as well as they thought. They have to pay the house, and taxes on their “winnings,” and even those people who win enough to cover all these costs aren’t any more likely to do it again in the future. “One thing kills off almost all the winners: time,” Mallouk writes. “With time, the winners in the stock trading game tend to become losers.”
3. Misunderstanding performance and financial information
There’s a lot of financial information out there, but that doesn’t mean it’s clear — and even if it is, that doesn’t mean we always understand or act on it correctly.
The first example Mallouk presents of a common misunderstanding is “judging performance in a vacuum.”
“Assume you have a room full of 12,000 people and tell them to flip a coin,” Mallouk writes. “If you repeat this about 13 times, someone will likely have flipped heads every time. We should not marvel at the brilliance of such a person. Rather, we should expect this outcome.”
He explains that money managers, who usually manage a handful of portfolios or funds, are bound to outperform the market sometimes. They highlight their best-performing portfolio or fund to wow a potential investor, but the reality is that this portfolio or fund’s performance doesn’t say all that much about the manager. Rather, one of his holdings was bound to do well by sheer chance.
“When you look at the vast reference set of mutual funds and hedge funds, the overwhelming majority underperform, and there is no evidence the winners will continue to win,” Mallouk writes. He says that you should ignore a portfolio manager’s past performance. “In fact, if you are working with an advisor who actually takes into account your personal situation … then the portfolio should be customised to a point that they cannot show past model performance.”
4. Letting themselves get in the way
When Mallouk writes about “letting yourself get in the way,” he’s adding his voice to those who encourage investors to admit what they don’t know — a typical investor isn’t an expert, and believing you are could lead to trouble.
“If you have a reasonable level of intelligence and you understand the basic principles of this book, you will likely outperform the great majority of investors,” Mallouk writes. “The key is to not mess things up.”
Mallouk says that emotional factors such as fear, greed, overconfidence, and mental biases lead to the biggest mistake investors make: letting themselves get in the way. “Take a step back, slow down, and follow the disciplined plan you have laid out for you and your family,” he writes. “The car is going to get to its destination, unless you personally drive it off the cliff.”
5. Working with the wrong advisor
Working with a financial advisor can be a smart idea, and Mallouk points out that high net worth individuals are more likely to do so, due to the increased stakes that come with wealth.
However, Mallouk says that most advisors do more harm than good.
He recommends making sure the advisor isn’t a broker who may earn commission through selling unnecessary securities, getting disclosure about that advisor’s compensation structure in writing, and, if planning is involved, making sure a certified financial planner is on the team.
“Understand the issues of custody and competence,” Mallouk writes, “but most importantly, make sure your advisor has no conflict and follows the investment philosophy that makes sense for you. Put your requirements in writing, and stick to them.”