A version of this article was published in the May 2013 issue of Morningstar ETFInvestor.
Being competent requires avoiding major mistakes. Yet I see time and time again investors making basic errors while spending a lot of time and effort trying to beat the market. That's like trying to join the NBA without knowing how to dribble the ball--the only difference is the NBA won't let you play, even if you show up to a game wearing a jersey and carrying a bagful of cash. The finance industry and its satellites, on the other hand, are more than happy to take your money.
Mistakes are so pervasive, so corrosive to portfolio returns, that it's worth cataloging them. Avoiding mistakes is one of the easiest and surest sources of profit for the typical reader. I believe there are three major types of mistakes investors make.
Failing to Understand and Manage One's Limitations
It's understood that for every trade there is a winner and a loser. Some mistake this to mean that beating the market is simply a matter of being in the top half of investors--not a high hurdle. Slightly more knowledgeable investors realize that transaction costs are involved, so they move the hurdle up to top third or top quartile. What many investors fail to realize is that skilled investors control a disproportionate share of capital. Because each dollar of outperformance must be offset by a dollar of underperformance, each skilled investor must be offset by many unskilled investors. Put another way, for every Warren Buffett, there are the many losers who stood on the other side of his trades, selling him things he bought, buying the things he sold.
This should scare any beginner. The hurdle is high. Even though I live and breathe investments, I worry about my own ignorance all the time. I know for a fact I have lots of wrong beliefs rattling in my head. The best I can do is to be conscious of this fact and try to root them out. The things I'm very confident in are precious few, and much of it composed of the knowledge of what I know I'm not good at. (If you can't identify many things you're bad at, you're probably overconfident.)
Of course, most investors try to hire someone who does know what they're doing. They hire people like Bill Gross to anticipate major central-bank policy shifts and Bruce Berkowitz to pick stocks. At least they think that's what they're doing. Most investors have been dragooned into the portfolio manager role, because the most important decision is really the allocation between stocks and bonds, and how that allocation evolves over time. That's a lever most investors keep firmly in their grasp.
Most investors make a hash of it, so much so that the standard financial advice is to keep one's stock/bond allocation static. It's good advice, to be discarded only after you become justifiably confident in your process. Even then, you might still be wrong. The way to render mistakes as harmless as possible is to keep fees as low as possible and portfolios diversified.
Failing to Understand Incentives
Many investors are naive when it comes to money. They believe that there are services and individuals out there desperate to offer any comers high returns and low risk.
As a newsletter writer, I don't promise any such thing. If I do a great job, I'll provide a few percentage points of excess return over a full market cycle. In fact, you can't reasonably expect any newsletter's advice to generate supranormal returns, because someone with the skill to do so would not be offering a newsletter (at least not for long--the biggest hedge fund in the world, Bridgewater Associates, actually started out as a newsletter).
Analyzing incentives is critical. It's a natural consequence of managing one's limitations. Investing will always involve dealing with people who know far more than you. One of the best ways to manage this problem is to understand how the people and firms offering your services are compensated. Good investors understand the importance of agency costs. If you look at stock analyses conducted by top hedge fund managers, one of the core questions they try to answer is how the firm's C-suite is given incentives to do the right thing.
Some cynics say that most peoples' main incentive is money. While there's a large grain of truth to that, I know for a fact that money isn't everything or even the most important thing. People care about other things, such as respect, autonomy, or even that warm feeling resulting from helping others. I know people who are smarter, more accomplished, and harder-working than me making far less money, because they have nonpecuniary goals. Everyone's different in their wants. When it comes to money it's almost never a good idea to put your trust in the hands of someone who cares only about getting more of it. If they know more than you, are smarter than you, they will get their hands on it some way or another. Warren Buffett himself says that the most important quality in a money manager is ethics.
Failing to Understanding the Basics
Defying common sense, some investors believe that they can be very successful without having a deep base of knowledge, as if ignorance were a badge of honor. The best you can reasonably expect with a weak grasp of the basics is to get lucky--either you put your money in the hands of someone who happens to be good, or you get lucky yourself and own things that go up in value.
There are certain concepts that an investor must understand to do a passable job investing. One is statistics and probability. An advanced level of knowledge isn't required, but it is essential to have an intuitive understanding that investing is a statistical exercise, where the luck of the draw dominates day-to-day, even year-to-year outcomes. Without feeling and knowing this fact down to your toes, you're liable to do silly things like react to noise generated by the market.
The other important topics include financial history, the incredible difficulty of forecasting the future, the ways humans are wired to misbehave, and so forth. I'm not going to go over them all. Needless to say, the basics encompass a body of knowledge that's at least book-length. If you're shaky, please buy a good book. I recommend "The Investor's Manifesto" by William Bernstein. I'm probably one of the few newsletter editors who'll encourage you to buy a book that, well, advocates not heeding to any newsletter. Bernstein is even more of a curmudgeon than I am and is actually somewhat distrustful of exchange-traded funds. (I hope you'll make a teeny-tiny exception and come back.)
I know I sound terribly self-interested, but I believe investing in low-cost index funds, a group that contains lots of exchange-traded funds, is one the best ways to avoid making big mistakes. ETFs are cheap, diversified, and tax-efficient. For the most part run by computers (with a helping hand from humans), they avoid many of the wedges that separate the interests of fund managers and shareholders. Index funds simplify the task of investing mainly to understanding and applying the basics of asset allocation. If you don't have the energy to manage your investments full-time, giving the task of trying to beat the market the respect it deserves, I believe that it would be a mistake to not invest much of your portfolio in them.
Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor