Are these 3 investment mistakes costing you 6 percent a year?

The average active, private investor underperforms the stock market by anything up to 6 percent a year.

6 percent may not sound like much when compared to the 20 percent or so that many investors expect, but consider this:

The team behind the Barclays Equity Gilt Study found that the stock market returns about 5% a year after inflation. If we assume that inflation will be 2% (the Bank of England’s target), then this gives a total expected future return of 7%.

If that turns out to be true, then the average active investor will get returns of around 1% before inflation but minus 1% once inflation is factored in.

In real terms, most stock market investors are losing money year after year

Over a 30-year investment period, a low-cost and passive index-tracking strategy returning 7% per year would grow by around 661% (620% after fees), while the average active portfolio would only have grown by 35%.

£100,000 invested in that passive portfolio would have grown to £720,000 compared to just £135,000 for the average active portfolio. In other words, the passive portfolio has produced gains that are almost 18 times greater than those of the active portfolio.

I find that shocking.  But more than that, I think it’s probably true.

It took me years to work out how to succeed as an active investor, and most never even make it that far

Many years ago, I was a happy and passive investor, riding the dot-com boom like so many others. Passive investing is easy when the market is gaining 20% a year.

But it didn’t – and couldn’t – last forever. In the dot-com meltdown of 2001, I did what many other investors did. I sold all my stock market investments in disgust and decided that perhaps the old adage of “stocks for the long run” wasn’t the way to go after all.

For several years I fiddled about with different strategies: Trend Following, Technical Analysis, and even something called CANSLIM.  You name it, I’ve tried it… and probably lost money on it.

And I’m not alone. I’ve seen other people do the same, and worse, like selling out with huge losses in the depths of the credit crunch in 2009 and completely missing the subsequent rebound.

More recently, Pete Comley’s book, Monkey with a Pin (where the 6 percent figure comes from), has made me realise that bad outcomes like this are endemic among private investors who stray, proactively or reactively, from the sanity of passive investing.

Where that 6 percent goes

Comley’s book also breaks down the 6 percent figure and shows how approximately 2% is lost to bad decisions, while 4% is lost due to making too many decisions.

Bad decisions come in two types, each of which contributes about 1% to investor underperformance.

Mistake #1 – Buying high and selling low

The first bad decision comes in two parts; buying high and selling low.

Simply put, when things go up, investors want to buy them and are willing to pay high prices in order to avoid losing out. Everybody else seems to be making money on the hot thing (dot-com stocks, property, gold etc.), and if you’re not, then you are a fool, or at least that’s how you feel.

When the opposite happens, and shares are falling, investors want to sell to avoid losing any more money, thereby selling low.

Even though they probably know it’s a bad idea to sell, they still do it to get away from the pain. Once the investor is back in cash, they can relax. Even if the market subsequently rebounds, as it so often does, they still feel pleased to be off of the “rollercoaster”.

Following the crowd, trend following, buying high and selling low. These things are eternal features of the human psyche.

That’s a shame because buying high and selling low is the opposite of the universal law of money making – which is to buy low and sell high.

Mistake #2 – Buying bad companies

The second bad decision is that of buying shares that go to zero or go down to some much lower price than you paid and never come back up again.

Even if you manage to avoid the first error by buying at a low price, if you haven’t done your homework, you can still end up with an asset that was cheap but is essentially worthless.

This is an occupational hazard for investors who are looking to buy into turnaround situations. But they’re not the only ones who have to look out for weak or failing businesses.

Over the long term, most companies that are in an index at any given time will leave. This could be for several reasons, including being taken over by another company, but in many cases, it is because they have either gone bust, or they have shrunk to the point where they are too small to be in the index any more.

Indices like the FTSE 100 get around this problem by simply replacing the companies that are shrinking with those that are growing (in terms of their market value).

Private investors, on the other hand, are more likely to hang onto an underperforming company in order to avoid turning theoretical losses into actual losses. Eventually, the company either goes bust or the investor has a negative return on the investment until they finally give in and sell.

Mistake #3 – Buying and selling too often

The 4 percent lost from making too many decisions is all down to trading costs. This consists of broker commission (2 percent), stamp duty (0.5 percent) and the bid/ask spread (1.5 percent). These costs are unavoidable, so there isn’t much that investors can do about them on a per-trade basis.

So the problem isn’t so much that the costs are there; it is the frequency with which they are taken from a portfolio.

If an investor buys the index and sells it 30 years later, then they will lose that 4 percent only once, which is the equivalent of a tiny amount (0.13 percent) each year.

If the investor replaces their entire portfolio each year (as the average investor does), then that 4 percent charge is applied every year. That’s a cost of 4 percent a year compared to 0.13 percent a year for the zero-effort passive approach.

It seems that holding each investment for less than a year is a good way to give money to investment brokers, market makers and the government.

Is there a way to get back that 6 percent?

Are active investors doomed to underperform the market by an average of 6 percent a year?  Is it not possible to reduce that figure towards zero? What about beating the market? Is that impossible too?

Unfortunately, not everyone can beat the market. Investing is a zero-sum game where one investor’s win is another investor’s loss. In total, we can only achieve the market’s return minus fees.

This is the ethos of the Vanguard Group and its spiritual leader, John Bogle, a man whom I admire greatly.

The principles of passive investing are that investors should seek to gain as much of the market’s return by investing in the whole market at the lowest possible cost.

Passive investing reduces most of the 6 percent underperformance by avoiding any form of trading. This reduces bad decisions and, of course, reduces trading costs.

But that throws the baby out with the bathwater. Active investors like to invest. They like to make decisions, and they want to choose exactly where and how their money is invested. They want to be able to tilt a portfolio towards income or growth, or large companies or small, to invest in various sectors, or focus in the UK or internationally. They want to be able to avoid military companies, oil companies, tobacco companies, or anything else as they see fit.

Passive investing gives nowhere near the degree of control that active investing gives.

The question remains:

Is there a way that active investors can retain the degree of control that they want over their portfolios, and yet invest sensibly, without excessive risk, and still match the returns of passive investors and perhaps even have a chance of beating them?

The answer seems obvious.  Just turn each mistake around and do the opposite.

  • Instead of buying high, buy low
  • Instead of selling low, sell high
  • Instead of buying bad companies, buy good companies
  • Instead of holding each investment for a year, hold them for 5 years or more

It sounds so simple.  And, in fact, it is.

As an investor, I’ve searched for timeless principles which can be used throughout an investment lifetime, which will apply as much 100 years from now as they do today.

Minor details may change over the years, but the underlying principles and the framework which binds them together should remain as steadfast in the next century as they have in the last.

In the mid-2000s, I found some of the timeless principles that I had been looking for.  They were in two quotes from a man called Benjamin Graham that dated back to the 1940s. Ben Graham was the mentor and employer of a certain Warren Buffett during the 1950s, and he is generally regarded as the father of value investing.

I have no doubt that these principles, combined with the principle of owning shares for years rather than months, will be as important 100 years from now as they are today:

“The selection of common stocks for the defensive investor is a relatively simple matter. Here we would suggest four rules to be followed:

(1) There should be adequate though not excessive diversification. This might mean a minimum of ten different issues and a maximum of about thirty.

(2) Each company selected should be large, prominent, and conservatively financed. Indefinite as these adjectives must be, their general sense is clear.

(3) Each company should have a long record of continuous dividend payments.

(4) The price paid should be reasonable in relation to its average earnings for the last five years or longer. We would recommend a price not to exceed twenty times such earnings. This would protect the investor against the common error of buying good stocks at high levels of the general market. It would also bar the purchase, even in normal markets, of a number of fine issues which sell at unduly high prices in anticipation of greatly increased future earnings”

“The stock of a growing company, if purchasable at a suitable price, is obviously preferable to others. No matter how enthusiastic the investor may feel about the prospects of a particular company, however, he should set a limit upon the price that he is willing to pay for such prospects”

Ben Graham

If you want a sensible approach to investing directly in the stock market, you won’t have to look much further than that.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

One thought on “Are these 3 investment mistakes costing you 6 percent a year?”

  1. 6% a year is sill far more than 0%.. I like this post; you’ve looked much further into investment mistakes than many others would. Some valuable info here. Thanks!

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