Updated: Feb 24, 2021
February 10, 2021
Kathleen J. Owens - Fiduciary | Financial Planner
You've probably heard about the recent incident with Robinhood traders driving up the price of GameStop, and AMC stock to tank a hedge funds short position on these stocks. This incident made me think about Robinhood investors as a whole and how many may be making serious mistakes. Please, if you want to start trading stocks, please educate yourself first. Don't learn as you go, or it will be an expensive education. Once you've made a terrible trade, there's no do-over. You've lost your money. There are probably thousands of these painful mistakes happening on a daily basis.
So here's my round-up of the most common mistakes us advisors see on a regular basis.
Following the herd
The growth of the trading app Robinhood is a good, although tragic example of following the herd. This trading app has become popular with young, perhaps inexperienced traders. According to The New York Times, their average investor is thirty-one years old. Many Robinhood users have gotten caught up in the frenzy because the trading is "free" and many of the typical trading check points that are found on all other trading sites, are absent on the Robinhood app. A check point is there to make you pause, and ask yourself; is the information that I have entered correct, and do I want to proceed with this trade.
Investing in the stock market is serious business, but the app presents it like a game. One investor got hooked on the app due to its appeal and “free” trading and lost $850,000 through financing his trades by getting cash from credit card advances and home equity loans.
With young investors following their herd and ease of use of the Robinhood app, has resulted in a deadly combination, literally. Recently, a 20-year-old college student, committed suicide when he mistakenly thought he had lost $730,000 while trading options. He tried to get help and answers from Robinhood support, but his plea for help was unanswered. Robinhood has claimed that the college students’ messages were returned. Apparently, the student did not know that options trades are displayed negative until the trade has finalized.
Treating investing as a sprint rather than a marathon
Yes, it would be nice if we could get rich quick. Unfortunately, that’s really hard to achieve. Historically, day trading usually ends badly. Yes, some people are successful, but the majority are not. To create true wealth takes decades, not days.
Being an emotional investor
One thing you learn as a professional advisor is to keep emotions out of your investment decisions. Decisions should be based on data, your investment goals and your ability to take on risk. People get carried away with emotion when:
1. they have a loss and then try to “make-up” for the loss, which usually leads to more losses due to emotion-driven decisions.
2. They get giddy with their success and become over confident in their ability. To keep the emotional high going, they ignore the losses and focus on their wins.
Believing the lowest cost solution is the best solution
The past few years, there has been a fee war among the major broker dealers (custodians) to attract new customers. This has led to “no-commission” trades and low management fees (expense ratio) on some funds. Yes, investment companies should not gouge their customers. However, the cost of the technology that is needed for rapid trade execution of millions of orders per day that are error free and also protected from external threats, is substantial. Custodians invest billions on the technology needed and employ highly educated professionals to carry out this very exacting, highly regulated and high-pressure work. Instead of focusing on the fee, look at your overall gain. Yes, some funds have higher fees, but what does their return look like? I'll take higher fees any day if I can get higher performance.
You'll step over a dollar to pick up a dime
What this means is that you focus on the wrong thing, which costs you money. Yes, we all want to save money, and the usual way most people think that they are saving money is by doing the work themselves. You may think, "stock trading, how hard can it be?" The problem is, you don't know what you don't know". I remember a story that relates to this when I was a new financial advisor. There was another advisor in the office, Bruce, who had been an advisor for a very long time. He was very successful and had a lot of loyal clients. He was kind enough to give me his time and chat with me. One afternoon he waived me into his office. He asked me, "Do you do your own taxes?" I thought, "What does he think, I'm too dumb to do my own taxes?" I answered, "Yes, I do my own taxes. He gave me a slow smile, that only comes with wisdom, and he said;
"I want to tell you a story when I was new to the business. My manager called me into his office one day and asked me the same question. I answered as you did, and with that my manager said, I'm getting my CPA on the phone right now so he can do your taxes".
Bruce thought, I can't say no to my manager, so Bruce agreed to talk to the CPA. The CPA asked Bruce to send him the past three years of his tax returns, which he did. About a week later, the CPA called Bruce and said he owed him $700.00 and that he amended his tax returns and would be getting a $7,000 refund. Bruce then said, he never did his own taxes after that.
This story taught me, that even though I'm a financial advisor and I have to know taxes, it's worth it to hire an expert.
Hanging onto your losers
It’s a normal tendency to avoid losses. According to Daniel Kahneman, Nobel Prize winner in economic sciences; we fear loss twice as much as we relish success. That’s why some investors will hang onto their losers and not sell. By selling you are then locking-in the loss and admitting defeat. Investing needs to be free of emotion.
How will you get to where you want to go when you don’t have a plan on how you are going to get there? Professional advisors take a great deal of time creating investment plans for their clients. This is our starting point. The plan will be tweaked and adjusted along the way as the market changes and the client’s situation changes. We wouldn’t waste our time with in-depth planning unless it was crucial to achieving successful outcomes.
No trading strategy
As part of an overall investment strategy is to consider when to buy and when to sell. Most investors buy rather easily. It’s selling that’s the tricky part. That’s where your overall plan comes into play. Using stop-losses strategically, ahead of time, sets parameters on your trades and helps remove emotion from the sell decision.
Not fully understanding the investment you are buying
Not understanding what you are doing has been tragically illustrated by the suicide of a young trader that was using the Robinhood app to trade options, which the young investor had no experience with. Options trading is complicated and risky. The twenty-year old investor thought he was -$750,000 in the hole, because he did not understand how an option trade is displayed. The investor reached out to Robinhood for help and guidance, but he was ignored (as reported by The Wall Street Journal).
Investment products are complicated. Ever read the full disclosure document on some leveraged funds? Most people don’t, but if you did and you understood everything that was disclosed in the document, you would probably have second-thoughts about the investment. Most often investors will turn to investment news channels, chat groups, blogs or friends to learn of investment ideas. Just because others are investing in a particular stock or trading strategy doesn’t mean it’s a good investment for you.
Not Using Spreadsheets or Other Means to Track your Portfolio Performance
Your money is your future and you should treat it as such. Investing takes time. It’s not fun or exciting reading investment reports and reviewing spreadsheets, but it’s necessary. You can't keep it all in your head. With good records you can spot trends and chart your progress. If you don’t have the time or inclination to keep a keep a keen eye on your investments then you should hand over the task to someone who will. Many of us are not detailed orientated or good with numbers. Being a good investor requires both.
During a time of volatility investors will fall into the trap of reacting. Again, this goes back to having a plan. For example, if you were invested in the stock market in 2008, what did you do? Did you panic sell or did you sit tight and ride it out? Were you actions part of your pre-determined plan? When you work with a professional advisor, together you will develop a plan for just this kind of situation.
Risk, what's that?
There's this thing that's kind of important. It's risk. With risk, it can be hard to describe with words, so investment professionals use mathematical calculations. Investments have many measures of their risk, in mathematical terms, and it's important to understand what these measurements mean. Standard deviation, Sharp ratio, Beta, r-squared and Value at risk are some of the well known measurements of a stock's or a fund's risk. If you don't know what these measurements are and how to interpret them, you can get yourself in big trouble very quickly.
Think worst case
Preparing for unpredictable events is part of an investment plan. We experienced this first hand, and are currently still experiencing a worst-case situation due to the Covid-19 pandemic. Who could have predicted such an event? Part of investing is to prepare for such “black swan” events. As professional advisors we run analysis on various portfolios to see how the portfolio with react to “black swan” events. Although the overall market has recovered nicely, there are still some sectors that are hurting. This analysis is something that individual investors don’t have the capability of doing.
Not understanding diversification and re-balancing
Simply put, diversification and re-balancing is not putting all of your eggs in one basket. I’ve had many conversations about diversification with clients and perspective clients about diversification and it’s usually when the market is up and the person does not see the benefit of the strategy behind diversification. They feel like they are losing out on making a higher return.
This chart, however illustrates the strategy beautifully. Yes, you are “leaving money on the table” when diversifying, but reducing your volatility. When the market is down, people appreciate diversification, when the market is up, not so much.
You see in the chart below, the stocks & bonds portfolios, give a “smoother ride”. A concentrated portfolio, (not diversified) can attain higher gains, but it can also produce deeper drops in value. Such as the S&P 500 Index (the green line) shown in the chart below.
The S&P 500 is an index of stocks only, which as you see, is more volatile the 60/40 (the light blue line) & 40/60 (the dark blue line) stocks & bonds portfolios. Most investors don’t have the “stomach” to tolerate a concentrated, non-diversified portfolio. Lot’s of investors want a higher return (don’t we all), but they don’t want the volatility that goes along with it.
Forgetting about taxes, your tax bracket and the different type of retirement accounts you should have
Our federal tax and retirement account regulations are complicated and can change every year. Do you have the time to keep up with the annual changes in tax and retirement account regulations? In 2020, the federal government changed regulations pertaining to withdrawals from retirement accounts. These changes have a beginning and end date. Do you know what these changes are so that you don’t make a mistake that could cost you thousands of dollars?
In addition, there are a variety of retirement accounts that can help you save more, defer or avoid further taxation, and pass on your account to an heir in an optimal way. Mistakes with these accounts can cost you with federal penalties and taxes if you don’t set-up and maintain these accounts correctly.
People forget about their investments
Day to day life becomes the focus of our attention and it’s easy to forget about the future. This is a major reason for people being unprepared for financial emergencies and retirement. The financial services industry has put great efforts into finding out why this is occurring and how we can help reverse this trend.
It is a sad statistic that currently, 21% of married couples, and 45% of unmarried people in retirement will rely on their Social Security monthly check for 90% of their income in retirement. Currently, the average monthly Social Security benefit payment for a 62-year-old is $1,130.00.
Another concern is there are an abundance of forgotten investment accounts; when people have changed jobs and forgot about moving their 401(k) account with them. Each year, it’s estimated that more than 900,000 401(k) accounts go unclaimed, in addition to $300M in unclaimed pensions, according to the National Registry of Unclaimed Retirement Benefits.
Some may think its people that have low paying jobs that don’t save because they don’t have much left-over money to save. But that’s not true in every case. If you are motivated and stick to it you can save quite a bit.
Here's a story I heard about a few years ago that really stuck with me. There was a school teacher that was a diligent saver. She put money into a retirement account month after month, year after year. She did live a simple life and never married, which helped her to save more. She donated her estate to a charity at her death and the charity was shocked that she had accumulated $7 million dollars! It is possible to accumulate a substantial investment account with early and often investing.
Working with a professional advisor utilizing a goals-based approach can boost your wealth by 15%, and having an advisor coaching you and holding you accountable can also boost your investment portfolio by 1.5%. These results were determined by the investment research conducted by Morningstar and Fidelity Investments.
Not understanding Social Security
We all know Social Security benefits are mysterious and complicated. There are a lot of factors that come into play. The year you were born, how many years you worked, how much you earned each year, and when you want to retire, just to name a few details to think about. Taking your social security into account when planning your overall savings strategy will help you to maximize the social security benefit you will receive and help you avoid costly mistakes.
This wraps up the major pitfalls an investor can encounter when going it alone without a professional by your side. I hope this information help you to realize it might be a good idea to take advantage of the benefits a good professional advisor has to offer.
I became a financial adviser to help people make good decisions and avoid making costly mistakes. I saw firsthand how my parents lost a lot of money due to poor decisions. They never sought professional advice about what they should do with their savings. They lost thousands in the stock market when they bought a stock that was a hot tip from a friend. After that, they never invested in the stock market again. If they had gotten competent advice, and agreed to, at the very least, a very conservative portfolio, they would have retired multi-millionaires. Instead, they invested in certificates of deposits, which did not even keep up with inflation.
Kathleen J. Owens
Fiduciary | Financial Planner
Aurora Financial Planning & Investment Management