Mistakes that even smart investors make

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Elliot Raphaelson

Everybody knows somebody who purports to be an investment maven. You might even like to consider yourself one.

However, while we always hear about the winning picks these favored few make, we don’t commonly hear about their mistakes. And, to hear Larry Swedroe tell it, “smart” investors make mistakes all the time.

Swedroe, a money manager and columnist for CBS MoneyWatch.com, has written a book with R.C. Balaban, Investment Mistakes Even Smart Investors Make (McGraw Hill, $28), which discusses 77 common pitfalls.

The book has been praised by John Bogle, Burton Malkiel and William Bernstein, financial experts I respect. Whatever kind of investor you are, you would do well to understand and avoid these errors.

Four biggest mistakes

Here are four that stand out in my experience.

Projecting recent trends into the indefinite future. Many investors make this mistake. To illustrate how prevalent it is, Morningstar tracked the performance of the least popular fund categories from 1987 through 2000 (“popularity” was gauged by the amount of cash flowing into and out of funds).

The study showed that the three least popular categories of funds beat the average fund 75 percent of the time, and beat the most popular funds 90 percent of the time.

Failing to consider the costs of an investment strategy. Active investors often like to scan the business press for investment ideas. Swedroe discusses a typical article from Business Week that profiled a successful analyst and his stock-picking results, which significantly outperformed the Dow Jones Industrial Average and S&P 500 index.

What pitfalls awaited the individual investor who wanted to borrow some ideas from this analyst? To begin with, the day after the analyst’s selections were made public, the prices of those stocks increased an average of 8.8 percent. Not many small investors likely got in ahead of that increase.

Also, most of the analyst’s recommended stocks were small-cap stocks with much higher trading costs. For some of the recommended stocks, there was a significant difference between the bid and ask price (amounting to 4.3 percent). Then there would also be commission costs.

After considering all these factors (which did not include tax consequences), a reasonable estimate of all the trading costs to replicate the analyst’s portfolio would have resulted in a total return less than that of the Dow Jones Industrial Average and S&P 500 index.

Blindly believing in hedge fund managers. Hedge fund managers try to outperform indexes such as the S&P 500 by buying and selling based on their perception of market mispricing.

AQR Capital Management studied five years of hedge fund data ending January 31, 2001. During that period, the average hedge fund returned 14.7 percent per year; meanwhile, the S&P 500 index outperformed the hedge fund average by almost 4 percent yearly.

Data from 2003 through 2010 show that the HFRX Global Hedge Fund Index had an annualized return of 2.8 percent, which underperformed every major equity asset class.

Many hedge fund managers are competent. However, the high fees that hedge funds charge, which range from 1 to 2 percent per year, plus 20 percent of profits, make it very difficult for them to outperform equity indexes.

Not understanding the arithmetic of active management. In 1991, finance professor William Sharpe wrote an article in a professional journal titled “The Arithmetic of Active Management,” in which he proved that active management, in aggregate, is a loser’s game. Sharpe showed that this is true not only for the broad market, but also for subsectors.

Active investors, on average, may expect exactly the same returns on a pre-expense basis as passive investors. To be sure, some investors will earn more than others, but some will earn less. The average expectation, again, will be the same as passive index investors — before expenses.

However, because expenses will be much higher for an active investor than for a “buy and hold” investor in an index fund, the active investor will have worse results on average. It may be more exciting to be an active trader, but it will not likely pay off with higher returns.

Best advice: Diversify

After discussing the many mistakes investors make, Swedroe and Balaban conclude with 12 recommendations. In my opinion, this is the best one: “Build a globally diversified portfolio of passive investment vehicles such as passive asset class funds, index funds, and exchange-traded funds consisting of multiple asset classes.”

It has been my observation that investors who try to select individual securities, to time the market, and to manage their portfolios actively are less successful than passive investors with well-considered investment objectives and diversified portfolios.

Elliot Raphaelson welcomes your questions and comments at elliotraph@gmail.com.
© 2012 Elliot Raphaelson. Distributed by Tribune Media Services, Inc.