Ways DIY Investors Can Improve Their Results Part 2

These are the ways DIY investors who buy individual stocks can improve their results.

1. Avoid An Emotional Response

Don’t let your emotions get in the way. Don’t hang onto losers to avoid recognizing your mistakes. Don’t become emotionally attached to security positions. Don’t hold securities hoping they will recover—don’t hold positions you would not buy today at today’s price. Hope is not a strategy. Don’t take extreme views and start to think that a terrible collapse is imminent—or that good times are here to stay and we’ll never see another 50% market crash.

Don’t treat different pools of money differently. Logically, money is money and whether the money was accumulated through a disciplined savings program, an inheritance, a bonus or a windfall profit, all of one’s capital should be managed with the same level of care.

Don’t overreact to either good news or bad news. Sometimes unexpected bad news is released and the share price drops within minutes, or an unexpected good thing happens and the price pops up within minutes. Usually within a year the impact of this event is negligible but DIY investors regret selling when the price was down or buying when the price spiked higher.

Don’t expect the current trend will continue. It is human nature to expect a current trend to continue. In a bull market we expect the market will continue to go higher. In a bear market we expect it will continue to go down. The reality is that trends always reverse themselves. As a general rule, investors should sell into a market that has risen significantly and buy into a market that has dropped significantly. The way to do this without trying to time the market is to rebalance the portfolio back to the target asset allocation

2. Be Sure You Measure Performance

Keep score. Don’t kid yourself about how well you’re doing. The simple solution (and benchmark) should be a Couch Potato portfolio of exchange funds—and you should compare your actual performance to this benchmark. Don’t be like a golfer who really enjoys the game and thinks that he plays better than average but doesn’t keep score and only remembers his good shots, forgetting all the times he four-putts.

Measure your performance against the proper composite benchmark. Most DIY investors are satisfied when they make a positive return, but rarely do they compare that return with the proper composite benchmark. DIY investors who don’t measure their return against the proper ETF benchmark should assume they are underperforming by at least 2% per annum.

Calculate the cost of underperformance (don’t be surprised if it is more than enough to buy a home). Based on experience, I expect that DIY investors who do not measure performance compared to the proper benchmark are underperforming by over 2% per annum. On a $500,000 portfolio underperforming by 2% per annum over the next 25 years this could mean having $400,000 less to spend in retirement.

3. Pay Attention To Income Tax

Pay attention to income tax efficiency. Income tax is our biggest expense and it is the ‘after  tax rate of return’ that is important. Tax efficiency can be achieved at the security level, individual manager level, at a macro level by choosing the proper location for different managers and securities, by choosing dividends or capital gains over interest income, by income splitting, estate planning, tax exempt insurance, or by using a ‘corporate class’ structure.

Don’t let the ‘tax tail’ wag the dog. Don’t allow your portfolio to become over-concentrated and expose yourself to more risk than necessary because you want to delay paying capital gains tax. All things being equal it is wise to delay the payment of tax—but it’s a mistake when the delay in the payment of tax requires one to be poorly diversified or to hold on to a security that should be sold.

Be sure to harvest your capital losses. Capital losses should be recognized and used to reduce the tax otherwise payable on capital gains.

4. Don’t Act On Bad Information

Understand that some professional managers do consistently beat the market. Few mutual funds consistently beat the market—but that is largely because of fees, over-diversification and ‘closet indexing'. Just as some professional athletes are better than others (and get paid more) there are some investment managers in each investment mandate with ten-year records of adding significant value.

Understand reversion to the mean. Reversion to the mean is a mathematical concept which in layman’s terms means that either for individual stocks or for the market as a whole, if the security is currently trading at a level (relative to corporate profits for example) that is above the long-term average, it will sooner or later be trading at a level that is below the long term average—and vice versa.

Know that individual investors lose when they buy fixed income investments. When investors buy bonds out of the bank’s inventory, they don’t know how much they lose on the spread. There is no transparency and investors always lose on the spread. When they buy corporate bonds they buy them without doing proper due diligence, because they don’t have the experience or resources for this type of investigation.

Too often DIY investors reach for higher yield without understanding the higher risk. Understand that ‘buy and hold’ is a not a long-term sound investment strategy. The DIY investor who likes to ‘buy and hold’ should realize that this strategy works well in a bull market—but not so well in a secular bear market. This idea first became popular after the bear market that ended in 1982. In the ’70s, anyone who followed a buy-and-hold strategy would have suffered greatly. In 1988 the Japanese Nikkei Index was at about 40,000—today it is at about 18,000. You would not want to be a Japanese buy-and-hold investor.

Don’t expect a particular style (e.g., value investing or growth investing) will always be the best. The investment style that is most effective will change from time to time. Some years ‘value’ investing will be best and sometimes ‘growth’ investing will be best. Few investment managers are expert at both styles. If professional managers don’t expect to be able to switch from one style to another and consistently beat the market, the odds are low for a part-time DIY investor to successfully switch from one style to another.

5. Be Logical In Your Analysis 

Focus not so much on fees—but rather value received. In many cases DIY investors started doing it themselves because they felt they were paying too much in fees. Any fee is too much if no value is being received—but high fees may be justified if significant value is added. The focus should not be on fees but on the value added. (To be able to measure value added, one needs a performance report which shows performance/net of fees compared to the proper composite benchmarks..

Don’t confuse investment ‘income’ with ‘cash flow.’ Investment income consists of interest, dividends and capital gains. To maintain their lifestyle, retirees need cash flow from their investments. One tax-efficient way to get the needed cash flow is to realize some of your capital gains. Some investors overlook the potential cash flow from capital gains and feel that to get the cash flow they require, they need to invest almost exclusively in securities that generate interest and dividends.

Don’t think that you can delay or avoid making a decision. Although some might wish to avoid making a decision, this is impossible. A decision to do nothing is the same as a decision to move to the existing asset allocation and to buy the existing portfolio of securities at today’s market price.

Don’t fall for the “it’s only a paper loss” line. Investors sometimes fool themselves by saying it’s not a loss until they sell it. That’s like saying they can avoid gaining weight if they avoid stepping on the scales. If an investor bought the stock at $10 and it now trades at $2, he has definitely lost money. Failing to recognize this fact simply delays getting the tax loss.

Don’t act on tips from a friend or colleague. Tips are like rumours and are usually based on faulty information. If the tip does result in making a profit, it may have been based on insider information, in which case anyone who acts on the information could have a legal problem.

Don’t put all your investment eggs in the one basket. Not only does this mean higher risk than necessary, it means you have nothing to rebalance to. When stocks go down, you want to be able to sell fixed-income investments to have the cash to buy stocks while they’re cheap. If you’re all in stocks all you can do is hold onto them—you won’t have cash to buy more.

Understand that with age you will eventually want some help with investing and you should develop a relationship with a fiduciary while you are still able to assess the fiduciary’s investment ability.

Sooner or later individuals lose confidence in their own ability to make wise investment choices. The transition to a professional manager should be done while one is still able to complete a critical assessment of the manager’s integrity and ability.

Summary: How To Manage Your Money Wisely.

1. Be clear on your financial goals and have a financial plan that shows the rate of return (and therefore the best asset mix) to achieve your goals.
2. Be diversified, address all the risks, but take no more risk than necessary to achieve your financial goals.
3. Focus on the investment process—this is more important than the investment products.
4. Use ETFs, a Couch Potato portfolio or professional money managers—don’t try to beat the experts by picking the best individual stocks.
5. Keep it simple.
6. Be efficient from an income tax point of view.
7. Insist on a report that shows actual performance compared to the proper benchmarks.
8. If you have more than you need, give some away so you can enjoy it while you are alive.

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