When it comes to fostering steady growth, retail investors are often their portfolio’s worst enemies. They get beat up by high fees and taxes, and knocked down by their own errors in judgment. In fact, one study released by the Yale School of Management in 2008 went so far as to call retail investing the “dumb money.” After tracking cash flow in and out of mutual funds to measure investor sentiment, the research found that in response to hype, general market enthusiasm or a mass exodus, “retail investors direct their money to funds which invest in stocks that have low future returns. To achieve high returns, it is best to do the opposite of these investors.” Or, as Jurrien Timmer, global macro strategist for Fidelity Investments, said in a recent speech: “The market is always out to punish most of the people most of the time.”
To avoid being a market lemming, retail investors need a solid plan, low fees and the Buffett-like temperament to just leave their holdings alone in times of turmoil. In short, you need to act more like institutional investors such as banks and pension funds. The tales of your investing adventures may no longer draw crowds at parties, but the consistent returns and reduced stress should more than make up for it.
PLAN YOUR FUTURE
Large institutional investors are good at focusing on long-term gains, and pension funds in particular must work to anticipate the needs of contributors decades in advance. Avoid “recency bias”—picking an investment product or stock that has been popular recently—and instead compose a written investment plan you can stick to. “If you assess your risk tolerance at about a five out of 10, you might choose a 50/50 policy for fixed income and stocks,” says Robert Abboud, founder of fee-based Wealth Strategies Investment and Financial Planning.
“Those kinds of plans remove the emotion and excitement from moving your money around.” It’s also important to think like a business when it comes to cash flow. “If people were really acting like an institution, they’d get a better handle on what’s coming in and going out,” Abboud says.
Much like a pension fund that buys securities with the money that flows in from paycheque deductions, retail investors can contribute equal amounts of money at regular intervals (say, monthly) in a strategy called dollar-cost averaging. “In 2008, all of our clients who were dollar-cost averaging did better than those who weren’t because they were buying everything on the way down,” Abboud says.
DIVERSIFY, THEN REBALANCE
Marshall McAlister, an Edmonton-based private wealth counsellor, is a proponent of “boring investing.” One big part of that strategy is diversification, which “isn’t just about protecting against bad things; it’s also about capturing the good surprises,” he says. McAlister points to economist William Sharpe’s research on risk and market sensitivity, which shows that you get the benefits of diversification when you’re holding between 25 and 30 securities. “But you need 30 things that act completely differently to get those benefits,” says McAlister. “When you own a Canadian portfolio of five banks and a couple of utility companies, everything acts the same.”
Retail investors can work to maintain a diverse portfolio by employing asset allocation strategies that force holders to maintain set percentages of different assets. This balances risk and reward by guiding investors to sell high and buy low to rebalance their portfolios (which advisers recommend doing about once a year).
CONFRONT YOUR RISKS
Risk and return go hand in hand, but many investors neglect the risk side of the equation— the chances of losing some or all of their principal. Bruce Cooper, vice-chair at TD Asset Management, likens that calculation to walking up to the plate in baseball. “You need to focus on hitting singles and not home runs,” he says. “You’re always going to have some holding off the side where you really want to knock a run out of the park, but this is where you have to be most disciplined.”
He recommends referring back to your plan and taking the minimum amount of risk necessary to achieve your financial goals. He also cautions that a few big mistakes can undo years of hard work. By contrast, pension funds are always focused on preserving capital in down cycles. “We say that if you’ve been a disciplined investor 95% of the time, it’s probably a failure,” he says. “Being disciplined doesn’t mean you’ll be right 100% of the time, but it means having a plan. You don’t need to gamble.”
LOSE LESS TO FEES
Good returns needn’t come with the expense of high management fees. “If you’re doing your own trading and analysis, then your fee should be a lot lower than someone who’s paying someone to assist them,” says Scott Plaskett, a fee-only planner and founder of Ironshield Financial Planning.
One way to avoid high fees is by investing in low-cost index and exchange-traded funds. Because these funds follow indexes, and there’s no fund manager choosing stocks and bonds, the costs associated with holding them are low. Index investing also mirrors the primary approach of the Canada Pension Plan, which aims to “create a portfolio that replicates the composition of major stock markets.” This could mean the difference between giving up 2.4% of the value of your assets every year to mutual funds with active management, and the fee of 0.5% a year or less for an ETF. That translates into thousands of dollars saved each year.
Taxes are another opportunity to be efficient. Income-producing investments like bonds belong in tax-free or tax-deferred registered accounts to protect against the high tax on interest. A financial planner may be able to catch this and other common pitfalls, like incurring deferred sales charge (DSC) penalties when selling mutual funds before they’ve matured. But “make sure you’re getting value for the fees you’re paying,” says Abboud.
ACT UNEMOTIONALLY, OR DON’T ACT
Individual investors tend to make mistakes because they let feelings like fear and greed infect their judgment. “I think we all have greed, and that’s OK. But you have two choices. You can invest, or you can be a speculator,” says Dave Richardson, vice-president with RBC Global Asset Management. Retail investors should act like stodgy pension funds by doing plenty of research and should resist making desperate gambles when they are frustrated. “People play the lottery because they want to become wealthy,” says McAlister, “but we know there’s a negative rate of return on that.” His attitude mirrors that of Nobel laureate economist Paul Samuelson who said, “Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”