Ways DIY Investors Can Improve Their Results Part 1
These are the ways DIY investors who buy individual stocks can improve their results.
1. Know the difference between the types of service providers who make a living in the financial services industry.
The exposure most investors have to the financial services industry is through individuals who are licensed as salespeople. These individuals may know a lot or they may know almost nothing about investing—and they may have a conflict of interest when making investment recommendations. Most investors would do better with a DIY portfolio of ETFs than by working with a financial advisor. On the other hand, investment counsellors generally have a CFA charter and many years of portfolio management experience; they act as fiduciaries, they provide useful performance reports and generally add value compared to an ETF portfolio. Investors should know that investment counsellors are a sensible alternative to the DIY route. http://weighhouse.com/resources/ White_Paper Choosing_the_Right_Advice_Channel.pdf
2. Don’t be over-confident
Don’t trade individual stocks without considering who you’re competing against. Think of it as a contest.
Most of the trading that takes place on the stock market each day is done by professionals, so when the DIY investor buys or sells a stock, someone else with more information, smarts and discipline (e.g. a hedge fund manager) is on the other side of the trade. If the professional wants to buy what you want to sell, you should ask yourself: what do I know that he doesn’t know? An individual investor trying to beat the professionals is like the weekend golfer expecting to beat Tiger Woods at golf.
Don’t underestimate the complexity of the stock market.
Some investors believe that if they know everything there is to know about a company they’ll be able to predict how the stock price will move. The reality is that unpredictable events such as global conflicts, unexpected innovations, new competitors, government intervention, what happens in China, social trends, etc., can all have a significant and unpredictable impact on the price of a stock.
Don’t assume that a high IQ is enough to ‘beat the market’.
The problem is that the investors on the other side of the trade (investment managers, professional traders and hedge funds) are also very intelligent and they have more information and a disciplined buy/sell strategy. Sir Isaac Newton was also very intelligent—and he lost everything in 1720.
Have someone challenge you on your investment ideas.
When working on your own it’s difficult not to fall in love with your own ideas. Individuals working in a group have to ‘champion’ their idea and convince others of its merits (while other members are doing the same thing with their pet idea) and this makes it more likely that a wise decision will be made.
Index at least part of the portfolio.
Some mandates (e.g., large cap US stocks) are followed so closely by so many analysts that it is practically impossible for any individual to discover information which is not already factored into the share price. Investors who want exposure to these investment mandates should follow the example of the large pension funds that get exposure to these sectors by buying a low-cost index.
Understand that what you read in the Report on Business is old news.
Professional investment managers usually know what is happening in a company long before it is reported in the ROB. By the time DIY investors read it, it is usually too late for a profitable trade. DIY investors should know that TV experts are expressing opinions and it’s easy to find other experts with the opposite opinion.
3. Follow a disciplined investment process
Understand what it means to follow a disciplined investment process.
The investing process is generally more important than the investment products. When investors fail to follow a disciplined investment process they’re guided by their emotions. If you don’t have a ‘sell’ strategy, you don’t have an investment strategy. One simple and effective strategy is to rebalance the portfolio according to the guidelines laid out in a written investment policy statement.
Develop Standard Operating Procedures (SOPs).
When firemen run into a burning building they don’t try to formulate a plan of action on the fly. Instead when they get inside they follow their SOPs, which they’ve practiced until their response is automatic. In a similar way, when markets are crashing or soaring investors should not have to think about what they’re going to do—they should follow their SOPs (as written in their IPS).
Develop an Investment Policy Statement (IPS).
A written IPS explains the investment process, the acceptable range for different sectors or investment mandates and the benchmarks against which to measure performance. Having a written IPS is like having a ‘touchstone’ that will help one avoid making decisions based on emotions.
Simplify your investment portfolio.
DIY investors often hold too many small positions— positions that could double in value and would still make no appreciable difference in the portfolio. These positions are too small to make much difference but they are a distraction. They may also hold complicated structured securities which make it difficult to understand fees, asset mix or inherent risk. They hold legacy mutual funds and small accounts which make it difficult to rebalance or even know how much is in each of the different investment mandates.
Don’t try to time the market.
Most investment managers agree that no one can consistently predict the top or the bottom of the market. Many can pick the top and get out at the best time – but these people rarely get back in at the bottom. In most cases those who get into cash at the right time often delay getting back into the market because at the bottom, they expect it will go even lower. A better strategy is to rebalance on a disciplined basis.
Don’t be a frequent trader.
With a well-designed portfolio and a disciplined process, one might only make a few changes each year.
Spend more time establishing the time to sell a stock position and less time trying to determine when to invest in a new position.
It is easier and more interesting to think about buying than selling. There is also less emotional attachment to a stock you’ve never owned than to one you’ve owned for years. However, deciding on which stock to sell and the price to sell it at is just as important as buying at the right time. Investors should write down their reasons for buying, their expectations at the time and the target selling price—DIY investors will in that way get a better idea of how right or wrong they are in their expectations.
Focus more on asset allocation and less on security selection.
There are studies that confirm that over the longer term most investors would be happier with the results if they focused more on the allocation between investment mandates and less on security selection.
4. Focus on managing risk
Don’t take any more risk than is necessary to achieve your goals.
The investment portfolio should be ‘goals based’ and if you can achieve your goals with a return of 4.5%, you should not have an asset mix designed to earn 6.5%. A financial plan is the most useful tool to help determine the proper asset mix. If you don’t have a financial plan that shows the rate of return required to achieve your goals you’re probably taking either too much or too little risk.
Be diversified by sectors.
Many DIY investors are over-concentrated in ‘core’ sectors with not enough in ‘enhancement mandates’ that can reduce volatility and/or enhance returns (e.g., small capitalization stocks, corporate bonds, commercial real estate, emerging markets, etc.). Some investors are overconcentrated in a few stocks. Many wealthy people made their money by holding a concentrated position, but they keep their wealth by being well diversified.
Be diversified internationally.
Almost 70% of the Canadian market is concentrated in three sectors. To have good diversification and exposure to sectors such as technology, health care, drugs, consumer staples, media, chemicals, electronics, auto, etc., one needs international exposure.
Limit security risk and market risk.
One cannot avoid market risk and still have a diversified portfolio—but there is no need to take more individual security risk (think Nortel) as well as market risk. DIY investors can limit individual security risk by investing in a portfolio of ETFs. The Couch Potato ETF models make a lot of sense.
Focus on managing risk and less on maximizing potential returns.
Investment managers focus on managing risk, whereas some DIY investors focus their attention on the potential for return rather than the potential for risk. When DIY investors purchase or sell a security they should make an assessment as to how the change will impact the risk of the portfolio as a whole.
Understand that in a rising market we all think we have a high tolerance for risk.
The problem is that markets always correct and sometimes by 50%. It’s only in the falling market that one’s tolerance for risk can be properly assessed. In a falling market, investors sometimes discover that their tolerance for risk is lower than they thought—their emotions take over and they sell at the wrong time.
Be sure to address all the risks.
Returns are easy to measure but it is more difficult to measure risk. Sometimes investors only begin to understand the risk after it is too late. Often DIY investors pay too little attention to the other risks such as inflation, currency, interest rate, income tax, liquidity, over-concentration, and hidden fees.
Don’t believe you can always be protected by a stop loss order.
The problem with a stop loss order is that if the market takes a sudden intra-day plunge of more than 20% it may not be possible to fill the order until the market bottoms. Then the sell order may be filled—just before the market rebounds.
Don’t forget the mathematics of a loss and a recovery.
If you have a stock that trades at $100 and it drops by 50%--so it is now trading at $50—you need a 100% increase in value just to get back to break even. Over time slow and steady returns (while not as exciting) will deliver a better result than higher returns which are punctuated by steep losses.
5. Focus on the big picture
Take time to clarify your financial goals.
If you don’t know what you want to achieve, you won’t know the rate of return you should be aiming for. Maybe you already have enough and you should be enjoying your wealth—or maybe you need to change your investment strategy and level of spending to achieve the things that matter most to you. Money is of no value unless it can be used to achieve goals and increase happiness.
Address the important ‘estate’ issues.
The reality is that we can’t take it with us. As they say, “the Brinks truck doesn’t follow the hearse.” If it is almost certain that there will be a surplus, wise individuals manage their affairs in order to get enjoyment by giving it away while they are living rather than have it all dispersed after they’re gone.
Keep your spouse involved.
Even if one chooses to continue as a DIY investor it may be important to develop a relationship with an investment manager so that one’s spouse would know where to turn for help if that becomes necessary. If no relationship is established while the most knowledgeable partner can provide advice, the surviving spouse may be the victim of the first salesperson who appears on the scene.
Understand the danger when more than money is at stake.
If a DIY investor is close to retirement or is retired and is financially secure, a big investing mistake could mean more than frustration and the children receiving a smaller inheritance. It might mean living a reduced lifestyle. When financial security is at stake, it becomes even more important to manage risk.
Focus on the right time horizon.
Most investors save for long-term goals such as retirement. For this objective, it’s the value of the portfolio at the date of retirement that is important. Short-term drops in value are unimportant and when a disciplined process is being followed, a drop in value can be an opportunity to rebalance. There is no sense in avoiding volatility over the next 30 years (before you need the money)—if a more volatile portfolio will give you more when you do need it.
Have a financial plan that shows how things will work out under different assumptions.
A properly prepared financial plan will provide financial peace of mind by showing how things will work out under different assumptions. It will also show what rate of return is necessary to achieve one’s goals and it will show what level of risk and what asset mix is most appropriate to achieve your goals.
This article to be continued in the March 2015 issue of Canadian MoneySaver.
Warren MacKenzie, CPA,CA is the founder of Weigh House
Investor Services and a Stewardship Counsellor with HighView Financial Group. Tel. (416) 640-0550
Email: warren.mackenzie@weighhouse.com