Volatile is an interesting word. It seems to be one we use when the stock market is moving, but not going straight up. The market is either plunging or seesawing. Statistics show the return of the average mutual fund investor is often below the return of the average mutual fund. Why? Because individual investors tend to make mistakes. Let us look at some.
The Seven Deadly Sins
Not all investors make the same mistakes. As a financial advisor, you caution your clients about several of them. But without the benefit of advice, investors can get themselves into trouble.
1. Carrying a large margin loan. There is a certain logic to using “OPM” or other people’s money. Unfortunately, when the stock market declines, all the pain is felt on the money you have put up. The loan doesn’t decease until you start paying it down. A good analogy would be a three-masted sailing ship heading into a hurricane. It would suffer great damage if you kept the sails up. If you couldn’t sail around the storm, you would want to pull down the sails, presenting as small a target as possible. Advisors warn clients about reducing their margin balance or keeping fresh cash aside for maintenance calls.
2. Selling your winners, holding your losers. Psychologically, we do not want to admit we were wrong. Investors often sell their winners, rationalizing “no one ever went broke taking a profit.” They hold their losers, rationalizing “they were early” or the stock will bounce back. Advisors remind clients to let their winners run and cut their losses early.
3. Ignoring asset allocation. Many investors (with an advisor’s guidance) start with an asset allocation aligned to their investment objective and risk tolerance. The markets are always moving. When times are good, clients should be taking money out of stocks and redistributing it within the bond and cash categories. When the market is heading down, they should be rebalancing by adding more money into equities. Investors can find themselves overweighted in stocks when the market decides to take a dive. Advisors are “beating the drum” of asset allocation when they conduct periodic reviews.
4. Ignoring diversification. Remember FAANG stocks? Everyone seemed to own the same stocks. Certain sectors and industries were favorites. Investors piled in because that was where you found the action. Some investors forgot the S&P 500 Index is composed of 11 sectors, each performing differently. Advisors counsel clients to avoid overweighting one sector and look for the sectors that are delivering positive returns or declining less.
5. Ignoring fundamentals. Ideally people buy certain stocks for a reason. They do something very well or have a new idea that meets a growing need. When the stock market declines, some investors “sell” getting out of good stocks at low prices. Advisors remind clients when a stock has declined 10%; this does not mean management is 10% dumber. They remind them why they own the stock.
6. This time it’s different. Many investors act on emotion, thinking the economic or political situation is a one-off event never seen before. They feel they are getting out early because the stock market will plunge and never recover. They act on emotion instead of analyzing the facts on hand. Although advisors cannot accurately predict the future, they often explain the market moves in cycles, but the length and depth of the cycles is undetermined. They remind them investors have been through difficult periods before.
7. Not considering tax consequences. Some investors think short term during volatile market periods. They consider themselves day traders, making money where they can. They do not keep track of the short-term gains (and losses) they incur, which can end up surprising them with a high tax bill. Good advisors help clients keep track of their realized gains and losses. They ask about their client’s activity in outside accounts, to get an understanding of the big picture.
These mistakes investors often make on their own also show how a good advisor adds value to the client relationship.
Bryce Sanders is president of Perceptive Business Solutions Inc. He provides HNW client acquisition training for the financial services industry. His book Captivating the Wealthy Investor is available on Amazon.