Your own worst investing mistakes

My friend Steve is one of the best investment barometers I know. He’s smart, confident, and always on top of the latest investment news. If something’s hot, Steve is buying. And if something’s not, Steve is dumping.

In 2005, Steve bought into the supremely hot U.S. real estate market. In 2007, he joined my investment club after we gained 17% for the calendar year. In 2011, he was buying gold.

He sold his American condo in 2009 when it lost value; he relinquished his investment club membership in 2008 when our portfolio got hammered; and now he’s thinking about selling his gold at a loss.

In each case, he bought what was rising after it rose, and sold what fell, after it dropped. That’s why Steve’s my investment barometer. If he’s buying something, it probably isn’t a good idea to follow suit. He buys recent winners, and it costs him plenty.

Steve’s behaviour is pretty common. Too many investors, unfortunately, look backward. They feel comfortable putting their money on yesterday’s front-runners, hoping (even expecting) they’ll continue their frantic pace. But most of the time, choosing investments based on how they’ve done in the recent past is a recipe for mediocrity—or worse.

We’re often attracted to hot currencies, sizzling commodities, mutual fund scorchers or sky-rocketing stocks. Neurosurgeon and investment author William Bernstein suggests that the part of our brains called the amygdala comforts us when we’re buying yesterday’s winners. We like looking for established patterns because they served our ancestors well. As Bernstein explains, “A hundred thousand years ago, if seeing a flash of yellow and black stripes in your peripheral vision was followed by the gruesome death of one of your companions, you do well to associate those two events.” But finance is statistically far less predictable than the behaviour of hungry tigers.

John Bogle, the founder of the Vanguard Group, explains this weakness in action when examining investors’ mutual fund returns. The average U.S. mutual fund from 1980 to 2005 gained 10% per year. But the average investor in those funds made only 7.3%—giving up more than one third of their potential earnings each year. Those mischievous amygdalae convinced people to add more money to funds that were winning, while selling (or not adding fresh money to) the funds that weren’t performing. They tried creating patterns where they didn’t exist, expecting a winning fund to keep winning and a losing fund to keep losing. Fear of low prices prevented investors from buying when their funds were low, and elation at high prices encouraged people to chase funds when the prices were higher.

Most of us, unfortunately, respond similarly to market stimuli. We react first and rationalize later. Even investment professionals can slip on their own bars of soap. Examining the flagship Canadian balanced funds from the Big Five banks paints an interesting picture. Most of them hold roughly 40% Canadian bonds and 60% Canadian stocks. During the past decade, stocks mostly surged (2003–2007), interrupted by the occasional dramatic collapse (2002, 2008). Did the fund managers fall into the psychological trap of chasing stocks when they soared, and abandoning them to chase bonds when stocks fell? I think they did.

During the 10 years from December 2001 to December 2011, the balanced funds from Canada’s big banks (TD Balanced Growth; CIBC Balanced; BMO/ NB Balanced; Scotia Canadian Balanced; and RBC Balanced Fund) were each whipped by an equally weighted portfolio comprised of TD’s e-Series Canadian stock index and TD’s e-Series Canadian bond index.

You might point to the higher fee structure of the actively managed bank funds as the culprit in their underperformance, but there’s more to it. If we discount the higher fees, those funds still fell short of their dispassionately indexed counterpart.

Perhaps you’re wondering if the actively managed mutual funds held foreign stocks, which—during the past decade—underperformed the Canadian stock market. If that were the case, they don’t hold them anymore. Foreign exposure, if any, accounts for less than 4% of the total for each respective fund.

Did the fund managers shun bank stocks while they were falling in 2008, only to stockpile them in 2009 and 2010 as they grew more expensive? Maybe. Or did they chase rising bonds or rising stocks when they should have been doing the opposite? Again, it’s entirely possible. The bottom line is that they underperformed. Even the professionals chase past winners.

But you don’t have to repeat their mistakes. Try owning a diversified, international collection of quality stocks or broad market indexes, in conjunction with a bond component. Maintain your desired allocation, adjusting once a year when soaring or falling markets cause your allocation to shift from the desired split.

You may want to use your age as a benchmark for the percentage of bonds you’ll have in your portfolio. If, for example, you’re 40 years old, you may want about 40% of your portfolio comprised of bonds, with the remainder in stocks or stock indexes.

The most important part is this: if you’re adding fresh money to your investments each month, and a specific stock or index that you own is rising in price, don’t add to it. Keep the allocation you started with by adding to bonds when your stocks rise, or adding to stocks when bonds rise. Control your primitive reactions. Sure, somebody you know is going to make a killing by bandwagoning on a hot stock or sector—perhaps by picking yesterday’s winner. But investing is a marathon, not a sprint.

Look at last year’s winners if you must. But don’t buy anything based solely on past performance. The biggest investment enemy, after all, is the one we face in the mirror each day.

Hey—just ask my buddy Steve about that.

Andrew Hallam is the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned In School.