Why Do Investors Lose Money?

There are two main reasons why retail investors lose money. The first is due to dealer malfeasance and/or advisor greed/incompetency. The second reason is related to investor behaviour. Of course there are market disruptions that cause losses despite the best laid plans of investors. In this article we discuss only the two main manageable sources of investor losses.

For the past 15 years we’ve interacted with retail investors, many of which have lost money investing in the market. From this database, we have some good ideas as to why investors lose money. Here is our list of the most significant ones:

• Dealer Fault

Most “advisors” work to the suitability standard. Under this standard advisors are not required to act in your best interest. The method of their compensation may influence their behaviour and the quality of recommendations they provide. Be aware.

• Defective Know-Your-Client (KYC)–risk profiling system places investor at risk from day one.

If the KYC is defective, advice will be unsuitable. Review your KYC form, at least annually, to ensure it's up-to-date, complete, appropriate, signed and dated. Anything you write on this form can and will be used against you in the event of a dispute. Don’t overstate your investment knowledge or risk tolerance.

• Rep mis-selling / investments that are unsuitable per your stated goals and constraints.

Selling a closed-end fund initial public offering almost always results in a client loss but great commissions for dealer/advisor.

• Misrepresentation of product risk and return potential.

Never invest in a product you don't understand. Ideally, you should independently verify information by thoroughly reading a prospectus Fund Facts, research reports, offering materials, annual reports, quarterly reports, brochures or other documentation

• Rep did not understand product e.g. leveraged ETF's—poorly trained advisor.

Unauthorized trading can lead to the unintended purchase of risky investments and lots of brokerage commissions. Check confirmation slips and account statements carefully. Look for evidence of unwanted transactions, credit or margin use. Take immediate action if you detect a problem. Time is critical. Contact the firm's branch manager. And send an email to the compliance department of the dealer.

• Poorly designed portfolio can lead to wrong risk-reward ratio.

Recommends a fee-based account when a more suitable and cheaper alternative is more appropriate.

• Account churning to generate dealer/Rep commissions.

Excessive leveraging/margin dramatically increased risk profile. Avoid borrowing to invest unless you are a seasoned investor, understand the risks of leveraging, have a need to take the risks and are confident you can financially handle all the risks. Read Investor ALERT: Borrowing to Invest http://www.nbsc-cvmnb.ca/nbsc/news_content_display.jsp?news_id=325&id=24&pid=4

• Off book sales often lead to risky, even fraudulent transactions.

Good warning from MFDA on Outside Business Activities. All retail investors should take the time to read this ALERT. This applies to IIROC dealers as well.

http://mfda.ca/investors/brochure/Fraudbrochure.pdf  

• Advisor fraud and theft.

Ponzi schemes always end up with clients losing money. If it sounds too good to be true, RUN.

• Client Fault

Investors are over-confident in their competency and ability to pick winners. It is human nature. Because of this, investors often over-expose themselves to concentrated positions. They believe so much in their one stock that they dump most or all of their money into it. Ultimately, when that one bad stock choice collapses, the investor gets crushed.

• Inadequate effort to select advisor—not ensuring a good fit.

Read Know Your Advisor:

https://www.canadianmoneysaver.ca/files/www/Know_Your_Advisor_KYA.pdf

• Not checking for unlicensed individuals.

Check out How to Check Registration of Rep or Dealer http://faircanada.ca/investor-resources/background-checks/

• Client knowingly overstates risk tolerance and capacity and investment knowledge (ego).

Provide the dealer with accurate information and don't inflate your net worth, income etc.

• Catching a collapsing stock without rhyme or reason.

Many investors see a stock down 35% on the day and assume it is a great buy. This is not the case. If a stock has fallen that much there is usually a major reason. Instead, only buy a stock if there is a technical reversal. In other words there needs to be something that signals a bottom. Investors need to have a specific reason to buy a falling knife, not just because "it seems cheap".

• Holding onto losers while selling winners quickly.

This is a common theme for investors. They cannot accept that a losing stock is a loser. They keep hoping it will turn around and keep believing in it. This is how a 10% loser turns into a 50% loser. On the other side of the coin, when a winning trade is up 10%, investors are so excited to see a gain, they take the profits and run. The portfolio math does not add up when you take 50% losses on your losing stocks but then only 10% on your winning ones. Always have a max stop and abide by it. In addition, determine ahead of time what the target on a stock is, and as long as nothing material has changed, stick with it.

• Panic selling during a market downturn—Buy high, Sell low—no long-term plan.

See Behavioral Bias - Cognitive Vs. Emotional Bias In Investing http://www.investopedia.com/articles/investing/051613/behavioral-bias-cognitive-vs-emotional-bias-investing.asp

Listening to sales pitches that make exaggerated claims about the expected profitability of a particular investment, or make specific price predictions, such as, "your money will double in six months." If it sounds too good to be true, it usually is.

• Investor disengagement—do not mitigate losses—does not look at account statements to track his/her investment account.

Investor insistence on certain investments such as occurred during the Internet boom/Nortel—today, marijuana stocks, Tesla, solar—disregard advice, chase “hot” stocks.

• Investor refusal to take a small loss (loss aversion) despite recommendation by advisor to sell.

• Lack of portfolio diversification—Canada-only focus, 100 % equity.

Instead, only put 5-10% of your portfolio in any one position. By diversifying, if any one position falls sharply, the other positions will help mitigate that loss by their gains.

• Lack of Financial competency—misunderstanding of risks. Solution:

Find an advisor you can trust (easier said than done; fee-only usually the best choice) or increase your financial competency.

• Fails to take income tax into consideration.

• Lack of streetproofing.

Signing blank forms, writing cheques to individuals, loaning money to Reps ultimately leading to losses.

• Overpaying for investment products and services.

Does not shop around, complacent, lazy, disinterested in money matters.

• Greedy, chasing returns without consideration of risk.

Does not understand that risk and return are relative.  

• Won't file complaint when losses occur.

Embarrassed, won't admit they were naive, don't want spouse or family to know. Many losses can be recovered but victims refuse to put in the effort even when told they have a solid case.

• Not learning from mistakes.

Read 12 Timeless And Invaluable Investment Lessons From Dilbert http://www.bigfatpurse.com/2015/01/12-timeless-and-invaluable-investment-lessons-from-dilbert/

• What Can You Do To Protect Yourself?

With the complexity of new products and cunning marketing pitches, retail investors will probably never be sufficiently financially literate to detect/prevent abuse. But all is not lost. Want to boost your financial competency? Become constructively critical. Use a Trust but Verify approach. Remember, salespersons in Canada are not obligated to act in your Best interests. Get Bay Street Savvy. Avoid getting derailed by Bay Street hype particularly “Free lunch” seminars.

If you rely on your advisor, make sure the investment meets your objectives and make sure you understand and are comfortable with the risk, costs and liquidity of the investment. Keep contemporaneous notes of your conversations with the advisor.

Read and understand the terms of any New Account Application Form you will be asked to sign with the dealer. Make an informed decision before agreeing to allow the broker to use discretion in buying or selling your investments. Be candid about disclosing financial constraints. Doing so should help prevent running into a problem. Also, fully understand how margin and other credit provisions work and the circumstances in which you could be asked to pay additional monies.

Demand to see the return rate of your portfolio over different time periods and the fees you are being charged.

Read Consumer Guide for financial and investment advice http://static1.squarespace.com/static/544e642fe4b04e8632c86a17/t/5457d5dbe4b0e16a796a64b8/1415042523818/Value-Dialogue-Consumer%27s-Guide_eng.pdf

• The Bottom Line

With a background of high Government debt and record high personal debt/income levels, reduced job security, lower-than-expected bond and equity returns and the prospect of higher inflation and taxes, the need to minimize losses has never been greater. Canadians are living in a world fraught with market risk, weak regulation/enforcement, complex structured products, powerful players and often unseen sales incentives like trailer commissions paid to “advisors” operating under the low suitability regime for advice. With workplace pensions no longer the norm and increased longevity of a rapidly growing seniors demographic, Canadians are increasingly vulnerable to industry wrongdoings and their own behaviour. Hopefully, this article will help improve your investing performance.

Ken Kivenko, PEng, President , Kenmar Associates, Etobicoke, ON (416) 244-5803, kenkiv@sympatico.ca, www.canadianfundwatch.com