The Investment Scientist

The two most common ways investors lose money

Posted on: December 13, 2012

New Year's investment resolutions

New Year’s investment resolutions

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.

Emotional Investing

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.

Get my white paper: The Informed Investor: 5 Key Concepts for Financial Success.

2 Responses to "The two most common ways investors lose money"

For those of us not used to legal terms, a counterparty is the other side of the transaction, i.e. the seller to your buyer. Their job is to get as much from you as legally possible. It’s not their fault if you buy a $20 gold-plated trinket for $400, it’s their goal.
Think this is a silly example? No, this is the whole business model of the Franklin Mint company. People buy their junk as an investment. Is it any wonder that J.P. Morgan or Merrill Lynch have the same business model, when it works so well? JPM and ML just have slicker ads and better lobbyists.

I have my assets divided into 4 areas. Each area has an entirely different strategy for success. The reason is the eggs and basket story, and the idea that if one approach is weak this season perhaps the others are stronger. Kind of like precious metals in a stock portfolio.

Two of these are institutional, with all of the expenses involve in that form of investing. The other two areas I manage myself.

It takes a great deal of discipline and sometimes it seems counter intuitive to manage investments. Many times when the broad markets are running from something, I find myself doing research and looking at buying it.

When I purchase a stock I want to buy it on sale, nobody pays retail. The world was built by the low bidder. Even the mansions of the wealthy were built on a low bid basis. So, I don’t buy the top of the trend. Then I set a realistic goal for that stock, based on what my expectations are after research. When it reaches the goal I sell, even if it’s in a roaring upswing. If I bought correctly and reached the target price, the party is over for me. I may miss the one that goes over the moon, but I will reach the goals I set.

It sounds wonderful. But, in reviewing this year I was up 18.6%. I looked at $ in vrs $ out and about 40% of what I bought were losers. I rehashed those only to find that there was nothing wrong with the choices, but the timing is important to. When we have markets that flinch when Greece has a riot, or Germany comes to aid, or China decides to hold down their currency you can have the right pick and buy at the wrong time and some other influence take the cash. This years goal is to weed out or improve the batting average.

Why do I mess with it? I like to learn, it is a form of diversification, I still keep 2/3 of the assets with the “pros”, and in an up and down world where a lot of financial planners are waiting for a rising tide, I get a kick out of finding something going up while they are waiting.

It’s not for the faint of heart. In march 2009, I was 100% cash. I had been since mid 2008. I was spooked. At the end of march I flipped that position to nearly all in. It turned out to be a good choice. What if I was wrong? It looked like a buying opportunity of a lifetime, but what if the Dow dropped another 50%? It could have on bad news from Europe. Disciplined investors don’t make sweeping moves like that. But, for the last 10-12 yrs buy and hold hasn’t worked well either, and I get older everyday. There are a lot points of view.

For investors, I think if your risk tolerence is too high, don’t get involved with stocks directly. It will make you crazy if the risk/fear aspect is too high.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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