In the past two years, the markets have experienced a global pandemic, negative oil futures prices, a supply chain crunch, astronomical returns in technology stocks, social media fueled short squeezes, a soaring housing market, and many other notable happenings. All the while, the U.S. stock market (as measured by the Russell 3000 Index) rose by over 47% for the two year period ended 12/31/21. After years of strong market returns, it is useful to remind oneself of common mistakes made by individual (and professional) investors.
Mistake #1: Over-Trading
Many investors trade much too frequently and it typically impacts their returns for the worse. Rampant trading can be a sign of emotional reactions to the economic and/or stock market news cycle and as is often cited, individuals are prone to making mistakes when acting out of emotion. While the commission cost of trading has virtually gone to zero, other costs such as taxes can eat into returns, especially when those taxes are on short-term capital gains. For example, in Massachusetts, short-term capital gains tax is 12%. Add that on to whatever your marginal federal income tax bracket is and you are quickly owing over 30% of the gain in taxes. Often times, it is better to sit back and do nothing rather than act. In doing so, you may prevent emotionally driven investment mistakes and minimize your investment costs. Reactive trading can be detrimental to returns.
Mistake #2: FOMO
FOMO, the fear of missing out, directly applies to investing as individuals chase the latest hot stock or fund. 2021 was filled with examples of stocks and funds that soared in 2020 only to experience sustained declines in the following year. Pandemic darlings Peloton and Zoom Video rose 434% and 396% respectively in 2020 only to fall 76% and 45% in 2021. 2020's hottest ETF, the ARK Innovation ETF, began 2020 with $3.2 billion in assets under management and ballooned to $34.4 billion by the end of the year (ARK Disappoints) as the fund returned 157%. Much of these inflows came in the last few months of the year and investors continued to pile in as assets hit over $50 billion by the end of February 2021. ARKK subsequently fell 24% in 2021 and investors have pulled almost $3b from the fund over the last 6 months, including almost $360 million over the last month.
It is reasonable to assume that the average investor in ARKK has not done very well on a relative nor absolute return basis given the cadence of inflows and fund returns. While this is not to say that ARKK will not go on to have great returns in the future, this example highlights a common investor behavior that is detrimental to the returns of their portfolios: investors chase recent returns and leave when recent returns turn south. If you are going to enter a recently hot fund or stock, just know that momentum can slow and reversion to the mean can be swift. Have your investment outlook rooted in a long-term approach.
Mistake #3: Overconcentration
This one is a double-edged sword: highly concentrated stock positions can lead to generational wealth, but they can also lead to sustained losses and long-term impairment of capital. This is the tradeoff of putting all of your eggs in one basket. According to research from JP Morgan, during the period from 1980-2020, over 40% of all stocks in the Russell 3000 Index have experienced a drawdown of at least 70% from which the stock price did not recover. These stats also vary by sector, with Technology stocks having the highest rate of such drawdowns at 59% of stocks. Additionally, only 10% of stocks had returns during this period that drastically outperformed the market (drastic being cumulative returns of over 500 percentage points greater than the market).
There are multiple behavioral biases that can prevent an individual from trimming a concentrated stock position. Individuals tend to value stocks more if they already own them than if they did not and were assessing whether or not to buy them (endowment effect). Individuals may regret not selling at a previously higher price and hope to break even on those unrealized losses by holding until the price returns to a previous high (anchoring bias). Individuals may also overvalue the stock they receive as compensation from their employer as they struggle to separate the success of the business, and their own success as an employee, with the valuation of the stock (these two can diverge a great deal).
At the end of the day, it is very difficult to distinguish which companies and stocks will go on to generate life changing returns. Devising a plan to reduce concentrated stock positions can improve your long-term chances of investment success.
Mistake #4: Leverage
Leverage enhances returns on both sides; good returns become great and bad returns become horrible. Take the case of Bill Hwang: the former hedge fund manager turned $200 million into as much as $30 billion before proceeding to lose $20 billion in a matter of a couple days (Bloomberg). Investing $5 of borrowed money for every $1 of equity invested will make that a possibility.
While this type of leverage is a non-factor for retail investors, the core principles still translate. The mistake here is more along the lines of investing money rather than paying down high interest debt such as credit card debt. With interest rates of 17-25% on a typical credit card balance, you need to beat that in the market to make it worthwhile to forego paying off that debt. This is unlikely and should your investments lose money, those losses are essentially magnified. The debate becomes more nuanced when considering investing vs. making extra payments towards a car loan, student loan, or mortgage. In those cases, you should consider what a reasonable rate of return is on your hypothetical portfolio vs. the hurdle rate of return, which is the interest rate on your debt.
Mistake #5: Mismatching Portfolio with Time Horizon
When building a portfolio, one of the main considerations in deciding on the target allocation is the investment time horizon. The length of the investment period should be a key factor in deciding how much to invest in stocks. As is frequently noted, the longer the time horizon, the greater the chance for stock returns that are both positive and superior to bond returns. However, in shorter time frames, such as a year or two, stock returns can be sharply negative. Below are examples using the MSCI World Stock Index:
1 Year Returns
3 Year Returns
10 Year Returns
Case in point, you don't want to be heavily invested in stocks if you think you are going to need the money within a year or two. On the other hand, allocating too little to stocks in a portfolio with a 20, 30, or 40 year time horizon would have a large opportunity cost. Stocks have tended to return 8-10% annually over long periods of time while bonds returned 4.09% per year over the 15 years ended 12/31/21. For short-term portfolios, allocating too much to stocks may result in taking losses when the money is needed. In long-term portfolios, allocating too little to stocks may result in an insufficient nest egg for retirement. The key is to balance the risk of your portfolio with the investment time horizon.
Mistake #6: Timing the Market
Peter Lynch once said "Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves". As seen in the 2020 pandemic, even when the world looks like it is about to fall apart, the market can be resilient. Additionally, there have been many great investors over the last decade who have called for a great bubble bursting due to high stock valuations relative to history or unsustainable levels of return or this, that, and the other, yet the market has continued to chug along. It is impossible to predict the near-term movements of the stock market and investors continue to do so at their own peril.
If you are fearful of a crash and feel compelled to sell out or feel hesitant to invest a lump sum, start by making incremental moves. Sell a little bit of stock and park it in bonds or cash and see what happens. Begin dollar cost averaging into the market and in the event that you are right, you will have the chance to systematically buy at lower prices. There are many stories of professional investors who were right about large market swings only to swing and miss on future attempts to do the same. The better option is to stay the course, build a diversified portfolio, and make some incremental asset allocation decisions when you must (i.e. by rebalancing your stock/bond mix when appropriate).
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