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Samuel Lee is a strategist on the passive funds
research team for Morningstar and editor of
Morningstar ETFInvestor, a monthly
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Beginner Mistakes
How to avoid them.
By Samuel Lee | 01-07-14 | 06:00 AM | Email Article
A version of this article was published in the May 2013 issue of Morningstar
ETFInvestor. Download a complimentary copy here.
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.
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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
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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.
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ETFInvestor Newsletter
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.)
Basic Strategy
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.

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Beginner Mistakes http://news.morningstar.com/articlenet/article.aspx?id=624997
5 of 8 1/11/2014 11:07 AM
Boomer165
Jan 10 2014, 6:00 AM
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Great writing Sam. I have found you to be one of the best writers
I've read over the last 30 years. Please keep doing what you are
doing.
sevendzboy
Jan 9 2014, 11:45 PM
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Great article. Sam - you seem wise beyond your years.
Understanding one's self and trying to control investment emotions
within a personal investment plan takes many years - you have
provided a great framework for readers here IMO.
Lengrav
Jan 9 2014, 11:22 PM
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Love your writings. I to am a Bernstein fan. I give the book
mentioned to new clients. I buy a dozen at a time. I'm a cpa.
yogibearbull
Jan 9 2014, 1:57 PM
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ETFs can trade in-kind w/o any tax implications. So they can kick
out lowest cost shares first, thus reducing future tax liability.
Indexed OEFs are quite tax efficient, but indexed ETFs can be even
more so.
mrpcid
Jan 9 2014, 12:59 PM
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Useful article.
"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."
Is it also true that low-cost index ETFs are more effective than
similar lost cost index open-ended funds?
Thanks
philodough
Jan 9 2014, 10:50 AM
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Sam - Good article as always. I enjoy reading your articles. There is
a grain of truth to capecod's statement - but so what - it comes with
the territory. When you start your own bridgewater let us be the
first investors.
I think the interesting question is how do you get over the investing/
Beginner Mistakes http://news.morningstar.com/articlenet/article.aspx?id=624997
6 of 8 1/11/2014 11:07 AM
cost of living issue. My Grandfather dollar cost averaged from the
1930s. Investing should be for the long term - but in the long term
were all dead. Investing is like watching paint dry. Like Bogle said in
one of his first books buy 15-30 quality blue chip stocks and hold
forever.
I guess the real question is how do you get your grub stake? Its
very hard for the average person to live off 4% of their portfolio. I
know the average person doesn't have a portfolio :)
felix
Jan 9 2014, 7:20 AM
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Thank you Sam for another helpful article. I don't detect any
"snootiness" or "self obsession." You are addressing a fact that is
rarely discussed by financial analysts, which is that throughout
history many people have lost significant amounts of money
investing in the market. Some have lost their savings, their houses,
and their retirement income. I would guess that almost any poster
at M* knows either a friend or family member who has suffered this
fate. Keep these heartfelt and thoughtful articles coming. IMO they
are among the best that M* has to offer.
SAM19454
Jan 9 2014, 6:07 AM
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rockymountians
With all your money and knowledge--why the hell are you, using
your valuable time here?
rockymountains
Jan 9 2014, 5:10 AM
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Billybob, I didn't mean to touch a nerve.
However, the point I was attempting to make is, understanding
your limitations when investing is by far the most important point of
all the points Sam Lee is making, in my opinion. The other points
are important but not nearly as much.
Whew, I have never had to explain the alternate use of the "noise"
term before but I will be much careful next time.
Billybob207
Jan 8 2014, 8:29 PM
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To Rockymoutains:
"Noise" = discussion that you don't agree with...or just don't like. So
many of us are just searching for commentary that makes us feel
"right". I am no different. But this article is spot on. Perhaps you
have put your money with some high priced guy or you actually
have beat the market over the last 10 or more years. If so, enjoy
Beginner Mistakes http://news.morningstar.com/articlenet/article.aspx?id=624997
7 of 8 1/11/2014 11:07 AM
your exceptionalism. That is not the norm. To each his own. Peace.


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