Ten Don’ts for DIY Investors
In my student days, I remember an ethics professor saying something to the effect of, “That which is not prohibited is permitted.” Of course, one pithy sentence does not exactly provide the full range of nuance that was elaborated on over the semesters that I studied ethics, philosophy, and theology. However, that thought does provide food for thought. Eliminate the clearly bad and what is left will incline you toward better choices.
This leads me to the topic of this blog post. Rather than suggesting that an investor follow a certain investment path, maybe the better advice is to point out the pitfalls that an investor would do well to avoid. Without further ado:
1. Don’t think of investing like a lottery.
This approach to investing still surprises me. The goal of many appears to involve hitting it big with a single stock pick that will turn into the next Apple, Microsoft, Alphabet (Google), or Amazon. I once spoke to an investor who told me he had invested his entire life savings in Netflix. If he managed to hang on over the intervening 10 years or so, then he may have done quite well, But investors who benefit from so-called lottery-like stocks are usually holding their positions for multiple years, which is not, I suspect, the mentality of most “investing = gambling” types.
2. Don’t try to beat the market.
A promise made by many actively managed mutual funds and many investment advisors is that they are worth their higher fees because their active management approach allows them to take advantage of opportunities to outperform the market when things are going well and take action to protect their investors when markets go south. There is little evidence that this can be done consistently. Mutual fund performance is thoroughly analyzed and is typically broken into quartiles, which is to say that each mutual fund in a certain category is measured against all the other mutual funds in that category and then divided into the top 25% of performers (1st quartile), the next 25% of performers (2nd quartile), the following 25% of performers (3rd quartile) and then the final and poorest 25% of performers (4th quartile). Very few funds can maintain consistent above-average performance. And, since relatively few of us invest in these top performers, on average, we investors will only get average performance less the fees we are charged. The better choice, therefore, is to aim for market performance and effectively increase performance by reducing costs through investing in index mutual funds or ETFs.
3. Don’t try to complicate it.
Maybe you are sold on low-cost broadly diversified investments, but you want to “tweak” things a bit to give you that extra edge. In these days of low interest rates, you may want more income, i.e., interest or dividend payments from sources other than standard bonds. So, you invest in real estate investment trusts (REITs), mortgage investment corporations (MICs), preferred shares, or high-yield (junk) bonds. The problem is that these investments are touted as equivalent to staid old government or investment-grade corporate bonds, with higher yields. The expression associated with them: “reaching for yield.” They all have higher risks attached to them and if they get in trouble, not only do you lose your yield, but you may also lose your invested capital. Essentially, they defeat the purpose of fixed income in providing the investor with ballast or a counterweight to the greater volatility you get from equities.
4. Don’t borrow to invest.
You can open a type of taxable non-registered account that is called a margin account. This permits you to borrow against the value of your investments to generate greater returns. For example, let’s suppose you have a margin account inside of which you hold a broad-based Canadian Equity ETF that has a 30% minimum margin requirement. That means 70% of the value of the ETF can be borrowed against to buy an additional investment. Let’s suppose the ETF is worth $100,000, which you had paid for in full, and you take the full loan value (excess margin) or $70,000 to buy an additional ETF. Since the new investment only requires 30% margin as well, you can maximize the amount you borrow by doing this simple calculation: Loan value ÷ required margin. $70,000 ÷ 30% = $233,333. You go ahead and buy the investment. You now have two investments worth a total of $333,333 ($100,000 from the first purchase plus $233,333 from the second purchase) while having only deposited $100,000 into your account.
This all works great when the investment goes up. A 10% ($33,333) increase in the value of your holdings means 33.33% growth in your $100,000 investment.
On the other hand, if your investment goes down by 10% your loss is equally magnified. A 10% drop in value means that your $333,333 is now only worth $300,000. You borrowed $233,333, but at $300,000 you only have the right to borrow $210,000. Suddenly, you need to deposit another $23,333.
If you think you have good reason to meet the call for another deposit, then you can do that. The alternative is to sell at a loss.
No less an investing luminary than Warren Buffett discourages borrowing to invest. He generally doesn’t like to invest in companies that use what he regards as excess leverage. Among his famous pithy sayings was, “Only when the tide goes out do you discover who’s been swimming naked.”
5. Don’t overestimate your tolerance for volatility.
I was licensed in the U.S., working for a discount brokerage from an office in London, ON, when the stock market meltdown occurred in the fall of 2008. People who thought they could handle significant volatility in their accounts, when faced with the massive ratcheting downward of the value of their holdings, found out that they couldn’t. Perhaps the same stomach-churning feelings were experienced in March of 2020.
If you had sold off all your investments and gotten out of the investment markets at either of those times, you would have missed out on a tremendous recovery. The lesson here is not to stick it out at a risk level that you cannot tolerate, because, frankly, if you cannot tolerate it, you will not be able to stick it out. Instead, invest at a risk level that you can tolerate. In other words, know yourself.
6. Don’t panic.
Even if you have the degree of risk set right for your personality and your desired investment returns, you might still find it emotionally tough to bear. Panic selling will lock in the losses that may otherwise be temporary. Volatility is a given in the stock market. Just look at the jagged returns in any chart.
S&P/TSX Composite Index as of 2022-03-07
The above 20-year chart shows the path of the index that closely tracks the performance of the Toronto Stock Exchange. You can see that although the general trend is upward, there are some pretty steep dives. Of course, if you were fully invested in the summer of 2008 and then went through that freefall until March 2009, you might have panicked somewhere along the way.
A sense of panic does not mean that you need to sell; it may just mean you need to remind yourself that the long-term trend of the stock market has been upward. If you have are a younger investor, consider that your assets may need to support you into your 90s. You can probably handle a periodic bear market given your time horizon. If you are older, then perhaps this is a reminder that you should adjust your investment portfolio to one that is more suitable to you given your expected lifespan and spending needs.
7. Don’t forget the reasons why you are investing.
The reason you are investing is NOT to get rich. Rich just means more money and has no limit. Rather, investing could be to help fund your retirement, perhaps it is to leave an inheritance for your heirs, or maybe it is to provide a bequest to a charity that is important to you. Brian Portnoy, the author of The Geometry of Wealth, suggests that investing and the creation of wealth is about reaching a level of “funded contentment.”
Defining wealth that way helps you gain a different perspective on your investing behaviour. You may even reach a point where you actually have the financial resources that you need so that you can substantially reduce the risk of your investment portfolio.
8. Don’t invest in individual stocks and bonds.
“Them’s fightin’ words,” as some gunslinger in an old western movie might say. However, I contend that investing in individual securities is unlikely to be successful in the long run.
First, consider that the market return of all the world’s various stock markets represents the average of all investors’ efforts.
Second, consider that while at one time the stock markets were dominated by individual investors, these days the stock markets are dominated by institutional investors who use highly sophisticated computer algorithms, have access to high-frequency trading platforms, and employ financial analysts who are highly specialized in their respective niches of the stock market.
Third, consider the “paradox of skill.” It used to be relatively easy to achieve market-beating returns because there was a wide range of participants in it. As participation by institutions increased, research in the field developed, and competition to enter the highest echelons of the investment industry tightened, the ability to be a standout performer either individually or as part of an institution (mutual fund company, pension plan, endowment, etc.) decreased.
For this reason, among others, the prudent long-run approach to do well is to simply seek to meet the market without trying to beat it.
9. Don’t trade more than necessary.
Perhaps you have heard the expression that goes something like this: “An investment portfolio is like a bar of soap; the more you touch it the smaller it gets.” If you have a systematic way to add money to your investment accounts, perhaps through an automated monthly contribution to your TFSA that will in turn be automatically invested in a low-cost mutual fund, I don’t think of that as trading more than necessary. Rather, I am concerned about the temptation to always “tweak” your investments, make an adjustment here or there, sell out of one fund for another one that is very similar but has an MER that is lower by 0.01%, or in the last year outperformed the fund you hold in some sort of futile performance-chasing exercise. Don’t do it. Determine your strategic asset allocation, find solid low-cost funds to meet that allocation, and stick with it over the long term.
10. Don’t forget to rebalance.
Perhaps somewhat contrary to #9 above, this is the one place where I encourage trading. Over a year or two, you will find that your long-term mix of investments has shifted. Let’s say that you had decided to go with a 60% equity / 40% fixed income portfolio on your $100,000 investment, broken out like this:
In a year, let’s suppose that your portfolio went up by 6.4% to $106,400. However, the growth was not even and came out like this:
As it turned out, your Canadian, U.S., and International equity positions all did quite well, but your emerging markets and fixed income investments had a down year. A strategy of rebalancing would have you sell off parts of your Canadian and U.S. investments and redirect those amounts to emerging markets and fixed income. Alternatively, if you were contributing new money to the account, you would put most of it toward the positions that dropped in relative value to restore them to their long-term target allocation* in your portfolio. That is the process of rebalancing, and those are good trades.
How frequently should you rebalance? There are two approaches. One is to rebalance when the difference from your long-term allocation gets too far away. Too far somewhat depends on your comfort level, but if you are rebalancing every two months, then you have probably set your parameters to be a bit too sensitive. A second option is to rebalance annually. This especially holds if you contribute to your RRSP and/or TFSA on an annual basis. That contribution time becomes your annual rebalancing opportunity.
Good luck on NOT doing these ten things in the coming year. Perhaps you have a few other ideas of what not to do you would like to share. If so, feel free to post them on the social media pages where this blog post appears.
*Long-term target allocation is not exactly a memorable phrase. Consider remembering this idea by using the acronym SAM (Strategic Asset Mix), a term coined by Steadyhand Investment Funds.
This is the 138th blog post for Russ Writes, first published on 2022-03-07.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.