The two most common ways investors lose money
Posted December 13, 2012on:
After working as a financial advisor for six years and after reading tons of research, I have developed a good sense about how the average investor loses money. As the New Year approaches, I think it’s good to share my insight so that readers can determine if they are making these mistakes.
Conflict of interest
I cannot emphasize this enough: Wall Street firms don’t work for you. If you have a Merrill Lynch or Morgan Stanley advisor, expect to give away 2.5% of your money every year – about half of it will be in explicit fees, the other half will be in hidden fees. If you invest through insurance products, expect to give up 3.5 percent of your money.
The logic is simple. The CEOs of these firms don’t get paid tens or even hundreds of millions of dollars thinking about how to make their clients richer; they get paid big salaries to maximize profits, which often means making as much profit as legally possible off of their clients.
It’s important to remember what Goldman Sachs’ CEO Lloyd Blankfein told a congressional committee investigating why Goldman was shorting junk mortgage-backed securities it was promoting to its clients: “They are our counterparties,” he said.
You should take the same attitude: all these big name Wall Street financial firms are your counterparties in a financial transaction, not your advisors.
This is an even more serious problem. Apparently, investors do not need outside help to hurt themselves; they hurt themselves well enough by watching financial pundits, such as Jim Cramer, and reacting to the market emotionally, to the tune of losing 4.5% a year, according to some research.
We humans are hard-wired to pay attention to changes. There was an investing experiment conducted at the University of Pennsylvania: Group A could only watch the level of the Dow Jones; group B could only watch the daily changes to the Dow Jones; and the control group could watch both, just like the average investor.
What they found was that group A investors reacted to the market a lot less emotionally and traded a lot less than group B and the control group. Is that surprising? No. If the Dow Jones was 13742 yesterday and today it’s 13472, that looks about the same to group A, but holy cow, to group B and the control group, it’s a drop of almost 400 points; better get out before it crashes.
Other research done by Terry Odean of Berkeley uncovered a linear relationship between how much investors trade and how much they lose. The title of the published research is “Trading is hazardous to your wealth.” You may infer the conclusion by its title.
The year 2012 is coming to a close. It’s time to ask yourself whether your investments suffer from either or both of these problems. Do you want to stop throwing away money in 2013? If you need help answering that question, schedule a portfolio review.
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