Despite some severe stock market downturns over the past 15 years, little has changed when it comes to how investors approach the stock market.

 

A September 2013 article in The Wall Street Journal lists the worst mistakes investors make: [1] poor timing, [2] lust (chasing recent returns), [3] pride (being overconfident), [4] sloth (overlooking costs), [5] envy (wanting to join the club), [6] wrath (failing to admit failure), [7] gluttony (living for today), and [8] greed (following the herd). Excluding number one (poor timing), these are the seven deadly sins. According to Morningstar, over the past 15 years (ending 12/31/2012), mutual fund investors averaged 4.6% a year while the funds they were in averaged 6.6% a year, a difference of almost 50%. Listed below are some possible solutions to these deadly sins.

 

Lust

Recency is a psychology term referring to an investor’s belief recent performance will dictate future returns. “Chasing returns” is one of the worst mistakes investors make. A good example of this is gold; its price increasing radically from 2001 through 2012, greatly outperforming stocks and bonds. However, long term, gold has barely kept pace with inflation and has greatly trailed stock and bond returns.

 

Solution: Avoid daily news (noise) and ads touting the latest popular investment. A good way to filter out trendy investments is to focus on an asset category’s 15-20 year track record.

 

Pride

Investors’ opinion of their investment skills is way too high. Being overconfident can be costly. Any investor who thinks he knows what the markets are going to do is fooling himself.

 

Solution: Look to an unbiased third-party source. Hiring an advisor by the hour or using a managed account can add needed objectivity. An outside advisor may also bring new ideas to the table.

 

Overlooking Costs

Studies consistently show more expensive funds underperform less expensive ones. The same is true with 401(k) fees.

 

Solution: Look at expense ratios, upfront commissions, and trading costs (which can equal or exceed the expense ratio). Mutual fund investors (in all categories combined, except money market funds) averaged 4.6% annualized returns over the past 15 years (source: 2013 Morningstar study).

Assume conservative yearly expenses of 1.2% (expense ratio + trading costs), returns could have been increased by 20-25% if a low-cost fund or ETF had been used.

 

Envy

It is a natural human trait to be attracted to a “great deal” only being offered to you or a select group. Many investors are drawn to a sense of exclusivity. The vast majority of these investments are hyped and often dangerous.

 

Solution: There are plenty of mainstream investments to satisfy all the needs of 99% of your clients. Focus on publicly traded assets with extensive track records.

 

Wrath

Based on their speeches, interviews and position papers, it appears that almost no political figure has every made a mistake. To a slightly lesser degree, the same is true with brokers. Psychologists call this “loss aversion.” A favored trick by many advisors is to not count paper losses (“it is only a loss if we were to sell it now”). The reality is a “paper loss” impacts net worth just as much as a realized loss.

 

Solution: Take responsibility for mistakes and your clients will respect you more. It is easy to blame market conditions or someone else, but investors eventually learn the buck stops with the advisor. If an investment strategy is not working out, it may be time to try something else. Do not focus just on a company’s fundamentals, consider investor sentiment, Fed policy, and the overall direction of the stock market.

 

Gluttony

Living for today may be a nice slogan, but it ignores the reality that our options become more and more limited the older we become. Investors need to make retirement less abstract and ask questions such as: What do they want their lifestyle to be during retirement? At what age do they want to retire? Where will they retire? What do they want to be doing during retirement?

 

Solution: Show a bar that represents the number of years until retirement and then another bar just below it showing life expectancy during retirement (likely to be 20-30 years). When your client sees this comparison, he/she may be more willing to start saving more.

 

Greed

The vast majority of advisors, investors, and professional money managers have a herd mentality. This is the exact opposite of what Charlie Munger and Warren Buffet do; instead of following the ticker tape and listening to “experts,” the Berkshire Hathaway duo study financials and talk to company management.

 

Solution: Focus on the investor’s goals and objectives. Doing what everybody else is doing means your track record is not going to be enviable. More importantly, the “flavor of the month” may not be appropriate for a client’s long-term financial plan.