The volatile swings in the stock market this year have made it tough for investors to determine the best moves to protect and grow their investment portfolios. Top financial advisor Barry Ritholtz says the surest way to improve your long-term performance is simple—stop making avoidable mistakes.
That advice seems obvious, of course, but even so, Ritholtz finds most small investors hurt themselves by taking too much action. They look for big winners…chase hot sectors…try to protect their downside by going to cash and jumping in and out of the market.
Reality: The way to get better investment results is counterintuitive—avoiding mistakes is more important than making bold moves.
Ritholtz advises small investors to embrace the boring…be as steady and consistent as possible, especially in volatile markets…and focus on reducing unforced errors. Here are five of his favorite secrets for avoiding investment mistakes…
- Don’t fall for denominator blindness. Small investors often get spooked and misled by big, scary numbers in media—headlines like “Markets Plummet 400 Points!” But the media often omit context for dramatic effect. To interpret the validity of a number in a media headline, create a simple ratio with a numerator and a denominator. Example: The Dow’s 400-point loss is the numerator. The denominator is the Dow’s recent level of 39,400. Upshot: The Dow actually fell less than 1%, a garden-variety loss that requires no action or response from most small investors.
- Be aware of your psychological biases. Biases are irrational assumptions or beliefs that distort our ability to make choices based on facts and evidence. They’re evolutionary phenomena hardwired into our nervous systems to help us survive. But in a modern-day environment, they can compromise our investment decisions. Three common biases…
Loss aversion. We feel the pain of a loss about twice as much as we derive pleasure from gains. That’s why we hang on to losing stocks rather than cut our losses.
Confirmation bias. We favor information that confirms our existing beliefs, so we tend to ignore data that doesn’t support the investments we own even if it’s important and relevant.
Recency effect. We make decisions based on recent events, expecting that those events will continue into the future. Example: When I was a Wall Street stock trader, I read the Wall Street Journal on my commute to work each day. But then I realized it was compromising the trading decisions I made, so I started to wait until the end of the day, after the markets closed, to read the financial news.
- Don’t panic sell. Whenever the stock market becomes disruptive, investors with long-term, diversified portfolios want to dump their holdings. While selling may quickly ease your anxiety, nothing wreaks more havoc on portfolios than decisions made to stop discomfort. Reason: Not only does panic selling lock in your losses, but you face the far more daunting decision about when to get back in once the markets start to rebound. Investors who retreat to cash rarely consider a repurchase strategy or the metrics on which to base those decisions. Studies show that among investors who panic-dumped their equity portfolios, about one-third never reinvested in stocks again…and the rest of the panic sellers tended to repurchase equities at a much higher price than they sold for.
- Don’t underestimate how difficult it is to pick big winners. Over the past three decades, only 2.4% of the thousands of public companies in the US accounted for all the stock market gains. Even if you had the skill and/or good luck to invest in one of those rare outsized winners, would you have had the discipline and insight to hold on to it through all the wild peaks and valleys in its share price? Example: In the early 2000s, I got my hands on a pre-release version of a new portable media device called the iPod. I was so impressed that I wanted to invest in the company even though Apple had been on the verge of bankruptcy. I purchased Apple stock at $15 per share. When it shot up to $45 in the next few months, I was thrilled and booked a 300% gain! But selling was the dumbest investment move of my entire career—since then, Apple stock has gained 74,000%, meaning that a $10,000 investment would have been worth about $7.4 million today.
- Don’t interrupt the compounding of your investment money. As an investment grows, you don’t just earn gains on your original principal. Your money compounds, earning gains on the accumulated gains incurred from prior years. This doesn’t sound like a big deal, but it is shocking how rich you can become from the power of compounding. Warren Buffett earned half of his entire net worth just since 2018. That’s why Buffett’s right-hand man Charlie Munger liked to say, “The big money is not in the buying or selling, but in the waiting.”
Positive Ways to Minimize Unforced Errors
If you can implement these best practices into your investing, you won’t just see better performance results…you will be a better, happier, less stressed steward of your own capital.
Create a diversified long-term financial plan that you can stick with…no matter what. It should be conservative enough that you won’t get scared and make hasty changes during short-term disruptions.
Invest most of your retirement money in passive index funds and exchange-traded funds (ETFs). I know it is boring being average…and you will never beat the market…but owning the entire market is the simplest, cheapest and most reliable way to find and hold on to those outsized winners that drive most overall long-term returns.
Own bonds for income and to offset stock volatility. We’ve been through an ugly bear market in bonds the past few years, but don’t give up on them. Stick with Treasuries, investment-grade corporates, municipals and Treasury Inflation-Protected Securities (TIPS).
Understand what is—and what is not—in your control. Spend your time worrying about what you can control…and roll with the punches on what you cannot. What you can control: Your investment plan…portfolio asset allocations…what you watch and don’t watch on TV…your behavior…the people you associate with professionally…maintaining your own ethical standards. What you cannot control: The Federal Reserve…elections…corporate earnings…unemployment rates…market volatility…government legislation…human nature … other investors’ reactions and panic.
Keep a cowboy account. This undermines much of what I told you above…sort of. If you are one of those people who love chatting about stocks at cocktail parties or can’t help acting on stock tips from financial gurus on TV, you need a way to indulge your inner hedge fund manager without jeopardizing your future. What to do: Set up an account separate from your main portfolio with “cowboy” money, no more than 5% of your liquid capital (e.g., $5,000 if you have $100,000 in liquid capital). If your cowboy bets work out, you’ll have had fun and got it out of your system. If it blows up, at least you didn’t touch your retirement assets.
