The hardest part of investing can be learning when to get out of your own way. As human beings, we are emotional, impressionable, and often a lot less savvy when it comes to investing than we think. That can spell disaster for portfolios.
After the fallout of the Great Recession, the SEC commissioned the Library of Congress to research "Behavioral Patterns and Pitfalls of U.S. Investors," a study that shines a harsh light on the shortcomings of individual investors.
Using sources from this and other reports, we've highlighted the pitfalls.
Researchers call it the "Disposition Effect" -- when foolhardy investors sell off "winning" stocks in their portfolio to lock in gains and hang tight to losers in hopes that they'll bounce back in the future.
In a study of 10,000 trading accounts at discount brokerage firms titled, "Trading Is Hazardous to Your Wealth," University of California business professor Terrence Odean found this method almost always had the opposite of its intended effect.
Once sold, the winning stocks went on to outperform whatever gains were earned by the losing stocks that the investor kept behind in his portfolio.
An August report by S&P Indices found more than 80 percent of actively managed U.S. stock funds underperformed the market in 2011. Why, you ask? Fees. The average mutual fund charges up to 3 percent of annual returns for the privilege of divvying up your investments, according to Forbes, which means they've got to promise returns of at least that amount for investors to break even.
"More often than not, a majority of funds underperform because returns are reduced by investment fees to cover fund operations, including costs to pay managers and analysts who support them," writes the AP's Mark Jewel. "Those fees are difficult to offset, even if a manager is a strong stock-picker."
Furthermore, the SEC cites a study by former University of Southern California professor Mark M. Carhart, who found "no evidence that portfolio managers are particularly skilled or informed, characteristics that would justify additional fees."
In an article published in The Journal of Finance and cited in the SEC's report, researchers found some pretty intriguing facts about investors who treat the market like an arcade. Of more than 66,000 households using a large discount broker in the mid-1990s, those who traded most often (48 or more times a year) saw annual gains of 11.4 percent, while the market saw 17.9 percent gains.
Finance brains call it "familiarity bias," the force that drives people to favor businesses they have some personal connection with when picking stocks. In its study, the SEC takes issue with the "particularly dangerous" way employees blindly buy into their company's stock.
"Not only does concentration in one asset violate the principle of portfolio diversification, but, if employees devote a large portion of their portfolios to their own company's shares, they run the risk of compounding their suffering if the company does poorly: first, in loss of compensation and job security, and second, in loss of retirement savings." Need proof? Just ask anyone who used to work at Enron.
Following everyone else to buy up "hot" assets is one of the surest ways to get burned. That kind of herd mentality, or "financial mania," as experts call it, happens when investors scramble to buy up stocks that are seeing large gains now in hopes that the trend will continue.
We saw the downside to this approach when the dotcom bubble burst in 2000 and again in 2008 when the housing bubble popped. The point is never to go all-in just because everyone and their brother says it's a sure thing. Keep your portfolio well-diversified, and you'll be better prepared to weather blows caused by downturns in the market.
In today's 24/7 news cycle, the media can be one of the biggest influences on small-time investors looking for a hot ticket in the market. This is a huge mistake, and one that the SEC says causes investors to "have poor timing, follow trends, and overreact to good and bad news."
"Although individual investors are net buyers of attention-grabbing stocks -- stocks that are in the news or that experience abnormal one-day returns or trading volumes -- these stocks subsequently do not perform as well as the stocks that the same investors decided to sell."
Let's go back to Odean's study on hazardous trading behaviors. In it, he noticed a trading frenzy each year around the same time: December.
It makes sense. Since changes to capital gains rates will typically go into effect after Dec. 31, investors scramble to rejigger their investments in order to minimize their losses in the new year. The Consumer Federation of America cautions against this approach in a recent report. "While individuals should be aware of the tax implications of their actions, the first objective should always be to make the fundamentally sound investment decision .... Some investors, rather than pay a large capital gains tax, will allow the value of shares in a well-performing stock to grow so large it accounts for an inordinate percentage of their overall portfolio."
Overconfidence can spell disaster for portfolios.
In his article, "On Financial Frauds and Their Causes: Investor Overconfidence," Monmouth University economist Steven Pressman found victims of financial fraud were often led astray by their own egos.
Think about it for a minute: It takes a seriously confident investor to throw all their money behind a business or mutual fund that promises extreme annual returns in spite of all research that shows the opposite is more likely. Ron McCabe, an Arizona businessman who lost his life savings when he invested in a "sure thing" that turned out to be a real estate Ponzi scheme, admits he was duped by the company's glossy presentations and pristine quarterly reports.
In addition, overconfidence is often cited as a reason that men tend to perform worse than women in long-term investing.
"Because women are less likely to indulge in excessive trading, they outperform men," according to the report. "Investors who use traditional brokers, remaining in touch with them by telephone, achieve better results than online traders, who damage their performance by trading more actively and speculatively."
It's all well and good to invest in low-cost funds you can "set and forget" over time, but it pays to seek advice from a skilled financial planner you trust at least once a year. The trick is finding the right kind for yourself.
We recommend choosing a fee-only financial planner, first and foremost. Unlike brokers, they're paid by the hour and don't work on commission for any of their recommendations, which means you'll get unbiased advice. When you've found the right advisor, half the battle is knowing which questions to ask. A good place to start: The National Association of Personal Financial Advisors maintains a database of fee-only financial planners in the U.S.
While the professionals chase risky options with high stakes, individual investors have the luxury of kicking back and shooting for the long-term.
"You can just buy low-cost passive funds," Henry Blodget writes in his book, "The Wall Street Self-defense Manual." "This will guarantee that you will beat most professionals, who are paid to try to beat the market and, therefore, can't buy low-cost passive funds." In short, if you try to beat the market, you will most often fall flat on your face. Two out of three mutual funds underperform the overall market in a typical year, according to Jack Bogle's Common Sense On Mutual Funds.