The most dangerous investment mistakes are those that go unnoticed. In this list, we’ll reveal 8 common investment mistakes you might not even know you’re making.
1) False Diversification
The most common one we see is false diversification. This occurs when an investor attempts to reduce risk through diversification, but instead just replicates that risk through new investments. This often happens when an investor buys a number of different funds without realizing those funds own many of the same stocks. This type of false diversification is called Fund Overlap, and it is a hidden risk that could be lurking in your portfolio.
2) Mental Accounting
This is by far the most egregious mistake we see and also the hardest one to realize you’re making. Mental accounting means you treat some of your dollars differently than others. For example, the money you make from work may be specifically earmarked to pay bills. But the money you receive from a tax refund may be used for a discretionary splurge, like a family vacation or a new watch. In reality, all dollars have the same exact value, no matter where it comes from. That means all dollars are vehicles that can be used to grow your wealth.
We’re not against treating yourself or your family, we know that’s one of the reasons you work hard for your money. But we would recommend having a pre-set plan for handling unexpected windfalls. For instance, come up with a percentage plan for handling excess income. Such as putting 25% into savings, 50% into investments, and 25% for discretionary purchases. That way if you end up with an unexpected bonus from work you’ll have a way of determining how much to save versus how much you can spend.
Remember when Bitcoin hit $20,000? And remember how everyone said you have to own it? Well if you bought it then, you were herding (you’re also down 50%, but that’s another story). Herding is when you follow the behavior of the crowd even if the risk and reward are skewed against you. The crowd is often wrong and we prefer to do the opposite of whatever they are doing. In fact, the crowd got it wrong again just two months ago when they sold out of stocks at the lows. So the next time everyone is telling you to zig, you might want to zag.
4) Media Response
We were told the impeachment inquiry against President Trump was going to crash the market. Instead, the S&P 500 just made a new all-time high and the impeachment doesn’t seem to be bothering investors one bit. The impeachment inquiry provided the latest example of media response in action. Investors who assumed such an event would cause markets to fall didn’t really think through the scenarios. Mainly, that actual impeachment would require 20 republican senators to vote against Trump. The S&P 500 is up 3.3% since the impeachment inquiry was announced on September 24th.
We were also warned of an imminent recession on August 14th when the 10-year and 2-year treasury curve inverted. The S&P 500 is up more than 8% since that day. If you’re basing your investment decisions on the headline of the day, you’re likely costing yourself money.
5) Loss Aversion
In 1979, two psychologists introduced a study that helps explain investor behavior today. They found that the pain of losing money is twice as powerful as the pleasure of making money. Loss aversion implies that some investors may be avoiding logical risk for fear of illogical losses. For example, the investor that keeps their money in cash, instead of a higher-return alternative like short-term Treasury bills are practicing loss aversion.
They invest in cash because they think they cannot lose anything. And by investing in something else, even something as safe as short-term Treasury bills, they fear they will lose money. In reality, when you invest in cash you are losing money due to inflation and opportunity cost. By trying to avoid risk you’re actually taking on the greatest risk of all: not being able to reach your financial goals.
6) Narrow Framing
Someone who makes decisions in a vacuum is often guilty of narrow framing. I had to help a client realize they were narrow framing recently when they wanted to enter a large position in Apple stock. This client was very bullish on Apple and wanted to buy the stock outright. However, her largest holding is a technology ETF whose largest allocation is to Apple. By default, this meant Apple was already the largest holding in her portfolio on a stock basis.
Had we bought the amount of Apple she wanted, we would have increased her total portfolio exposure to Apple by 150%. After we talked about the risks and rewards associated with buying Apple outright, we instead just decided to buy more of the tech ETF she already owned. Anyone who is mixing index fund investing with selective investments in individual companies should be conscious of narrow framing.
One of the most dangerous things an investor can do is assume the same outcome twice. That goes for positive or negative outcomes. Just because something worked before doesn’t mean it will work again. And just because something didn’t work before doesn’t mean it won’t work again. Anchoring is when you rely on past experience, even if it isn’t a good comparison. We see this a lot when investors find themselves in bad investments. One of the first things they say is, “Well, that stock came back for me so I think this one will too.”
Everyone can you tell about the time they could have made a million dollars if they had just done this or that. It’s only natural for investors to think about the negatives associated with their decisions. That’s the basis of regret. When we didn’t have the actual experience of something, we automatically think it would have played out perfectly. For example, we owned Beyond Meat (BYND) for a client earlier this year. We bought it for $65, sold some at $130, and the rest at $170. Overall, the stock hit $230 after we sold.
I remember the client wishing we had bought more and being disappointed that we sold out before the share price moved up to $230. I countered that had we bought more, he may have turned greedy and argued against selling any! Instead of feeling regret for not buying more, I encouraged him to feel incredibly smart for having the foresight to recommend we buy BYND in the first place.
Rather than being disappointed we could have sold for $230 I asked the client how he would feel if we were still holding it? I showed him a chart of Beyond Meat since we sold and pointed out that it is 45% lower from our average sale price. Everything we did with our investment in Beyond Meat turned out to be a good decision. Outside of having perfect timing and foresight, there’s not much else we could have done better.
It’s all a mental game
Yogi Berra once said that 90% of baseball is half mental. That’s one of my favorite quotes and I believe it can be aptly applied to investing. The investment mistakes mentioned herein are not going to jump off the page when you’re reviewing your portfolio. Instead, critical thinking about your own emotions is required to discover the truth. If you saw a little bit of yourself in any of these descriptions that’s not a bad thing. The crime is if you let one of these mistakes go unnoticed.
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