Investment Mistakes Even Smart Investors Make and How to Avoid Them

Overview

EVERYONE MAKES MISTAKES. THIS BOOK SHOWS YOU HOW TO MAKE MONEY.

“Swedroe and Balaban show you how to avoid being your own worst enemy and how to win the investment game by not losing.”
—Burton G. Malkiel, author of A Random Walk Down Wall Street

“Sure, we’ve all made mistakes, and they can be pretty expensive, even the first time. This wonderful volume will pay for itself a thousand times over.”
—William Bernstein, author of A Splendid Exchange...

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Investment Mistakes Even Smart Investors Make and How to Avoid Them

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Overview

EVERYONE MAKES MISTAKES. THIS BOOK SHOWS YOU HOW TO MAKE MONEY.

“Swedroe and Balaban show you how to avoid being your own worst enemy and how to win the investment game by not losing.”
—Burton G. Malkiel, author of A Random Walk Down Wall Street

“Sure, we’ve all made mistakes, and they can be pretty expensive, even the first time. This wonderful volume will pay for itself a thousand times over.”
—William Bernstein, author of A Splendid Exchange and The Investor’s Manifesto

“In his new book, Larry Swedroe—America’s preeminent writer on passive investing—shows you how to recognize your mistakes and, more importantly, how to avoid future mistakes to secure a worry-free financial future. This book will prove to be a classic blueprint on sidestepping the blunders made by even the smartest of investors.”
—Bill Schultheis, author of The New Coffeehouse Investor

“This is a book that does not belong on your bookshelf; it belongs in your hands. Buy it, read it (and it’s fun reading), and prosper.”
—Harold Evensky, President, Evensky & Katz Wealth Management

“Swedroe’s tour through the world of money and psychology is a trip every investor should take.”
—Gary Belsky, coauthor, Why Smart People Make Big Money Mistakes...And How to Correct Them

With a Foreword by Meir Statman, author of award-winning What Investors Really Want

Even the most experienced investors in the world can screw up—and don’t let anyone tell you otherwise. Whether you’re an old pro with a well-designed portfolio or a newbie investor just starting out, bestselling author Larry Swedroe with RC Balaban can show you how to “live and learn” from others’ mistakes—and invest in good times and bad.

By answering the key questions every investor should ask, you’ll learn how to avoid:

Mistake #1: Feeling too confident in your investing skills

Mistake #6: Allowing yourself to be swayed by popular opinion

Mistake #11: Holding on to assets because of the price you paid

Mistake #15: Letting friendships influence your choice of advisors

Mistake #31: Expecting miracles from hedge fund managers

Mistake #48: Confusing speculation with investing

Mistake #60: Underestimating the number of stocks you need to diversify

Mistake #71: Forgetting that you can be too conservative

Mistake #77: Repeating the same mistake

Be warned: This groundbreaking guide will shatter the myths about money you’ve come to accept and challenge the conventional wisdom you’ve received from friends, advisors, and other “experts.”

By exposing these all-too-common mistakes, one by one, you’ll be able to rethink your strategy and reinvest in your future with confidence. You’ll discover the truth about misleading demographics, “high-return” investments, active managers, and other resources you should—or shouldn’t—trust.

You’ll learn the actual devastating effect taxes can have on your returns if you use the wrong strategy. You’ll learn the wrong way and the right way to build your portfolio, diversify your accounts, and plan for your family’s future. Most important, this book will show you how to avoid making the investment mistakes you used to make and how to give yourself the best chance of achieving your financial goals.

Filled with insider insight, need-to-know advice, and revealing case studies, this is the one book smart investors can learn from—and even smarter investors can invest in.

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Product Details

  • ISBN-13: 9780071786829
  • Publisher: McGraw-Hill Professional Publishing
  • Publication date: 12/13/2011
  • Edition number: 1
  • Pages: 224
  • Sales rank: 807,316
  • Product dimensions: 5.90 (w) x 9.10 (h) x 1.20 (d)

Meet the Author

Larry E. Swedroe is the bestselling author of the The Only Guide series and other successful investment guides. He writes the blog “Wise Investing” for CBS MoneyWatch.com and speaks frequently at financial conferences. He is also a principal and Director of Research for The Buckingham Family of Financial Services, which includes Buckingham Asset Management and BAM Advisor Services. In addition, he has held executive-level positions at Prudential Home Mortgage, Citicorp, and CBS.

RC Balaban is a former journalist and currently the media specialist for The Buckingham Family of Financial Services, which includes Buckingham Asset

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Read an Excerpt

Investment Mistakes Even Smart Investors Make and How to Avoid Them


By Larry E. Swedroe RC Balaban

McGraw-Hill

Copyright © 2012 Larry E. Swedroe and RC Balaban
All right reserved.

ISBN: 978-0-07-178682-9


Chapter One

MISTAKE 1 Are You Overconfident of Your Skills?

People exaggerate their own skills. They are optimistic about their prospects and overconfident about their guesses, including which managers to pick. —Richard Thaler

Jonathan Burton, in his book Investment Titans, invited his readers to ask themselves the following questions:

* Am I better than average in getting along with people?

* Am I a better-than-average driver?

Burton noted that if you are like the average person, you probably answered yes to both questions. In fact, studies typically find that about 90 percent of respondents answer positively to those types of questions. Obviously, 90 percent of the population cannot be better than average in getting along with others, and 90 percent of the population cannot be better-than-average drivers.

While, by definition, only half the people can be better than average at getting along with people, and only half the people can be better-than-average drivers, most people believe they are above average. Overconfidence in our abilities may in some ways be a healthy attribute. It makes us feel good about ourselves, creating a positive framework with which to get through life's experiences. Unfortunately, being overconfident of our investment skills can lead to investment mistakes.

The following illustrates this effect. A survey of investors about expectations of returns found they persistently forecasted that their portfolios would outperform the market.

Another great example is a February 1998 survey by Montgomery Asset Management. It found that 74 percent of investors interviewed expected their funds to consistently outperform the market. It is simply impossible for the average investor to beat the market since investors collectively are the market. The logic is inescapable: the average investor must, by definition, earn market rates of return, less the expenses of his or her efforts.

In a New York Times article, Professors Richard Thaler and Robert J. Shiller noted that individual investors and money managers persist in their belief that they are endowed with more and better information than others and that they can profit by picking stocks. This insight helps explain why individual investors believe they can

* Pick stocks that will outperform the market

* Time the market so they're in when it is rising and out when it is falling

* Identify the few active managers who will beat their respective benchmarks

Even when individuals think that it is hard to beat the market, they are confident they themselves can be successful. Here is what the noted economist Peter Bernstein had to say: "Active management is extraordinarily difficult, because there are so many knowledgeable investors and information does move so fast. The market is hard to beat. There are a lot of smart people trying to do the same thing. Nobody's saying that it's easy. But possible? Yes." That slim possibility keeps hope alive. Overconfidence leads investors to believe they will be one of the few who succeed.

Remember that to profit from the market's mistakes, either you must have information the market doesn't have (and remember, if it is inside information, you cannot legally trade on it), or you must interpret the information better than the collective wisdom of the market. Obviously, not everyone can be above average in doing so. And to beat the market, you must be well above average since you incur expenses in the effort.

Let's take a look at some further evidence on investor overconfidence. Brad Barber and Terrance Odean have done a series of studies on investor behavior and performance. The following is a list of their main findings:

* Individual investors underperform appropriate benchmarks.

* Though the stock selections of women do not outperform those of men, women produce higher net returns due to lower turnover (lower trading costs). Also, married men outperform single men. The obvious explanation is that single men do not have the benefit of the spouse's sage counsel to temper their overconfidence. It appears that a common characteristic of human behavior is that, on average, men have confidence in skills they don't have, while women simply know better.

* Individuals who traded the most (presumably due to misplaced confidence) produced the lowest net returns.

Overconfidence causes investors to see other people's decisions as the result of mood, feelings, intuition, and emotion. Of course, they see their own decisions resulting from objective and rational thought. Overconfidence also causes investors to seek only evidence confirming their own views and ignore contradicting evidence. The late John Liscio, respected veteran bond reporter and founder of the Liscio Report, put it this way:

Forecasters, by definition, are biased and untrustworthy recorders of current economic events. In other words, they tend to uncover evidence that supports their forecasts, and they ignore or analytically dismiss anything that challenges it. And, even if the headline data appear to contradict their disclosure of the universe, they will undoubtedly uncover some statistic or extenuating circumstance that dovetails neatly with their worldview.

Examining the results of the Mensa (a high-IQ society) investment club provides an amusing bit of evidence on over-confidence. If any people deserve to be confident of their skills, it seems logical to believe that it should be the members of this group. Yet the June 2001 issue of SmartMoney reported that the Mensa investment club returned just 2.5 percent over the previous 15 years, underperforming the S&P 500 Index by almost 13 percent per year. Warren Smith, an investor for 35 years, reported that his original investment of $5,300 had turned into $9,300. A similar investment in the S&P 500 Index would have produced almost $300,000. One investor described his strategy as buy low, sell lower. The Mensa members were overconfident that their superior intellectual skills could be translated into superior investment returns.

Wall Street Journal columnist Jonathan Clements made the following observation: "Beat the market? The idea is ludicrous. Very few investors manage to beat the market. But in an astonishing triumph of hope over experience, millions of investors keep trying." Overconfidence helps explain this triumph of hope over experience. Investors may even recognize the difficulty of the task, and yet they still believe they can succeed with a high degree of probability. As author and personal finance journalist James Smalhout put it, "Psychologists have long documented the tendency of Homo sapiens to overrate his own abilities and prospects for success. This is particularly true of the subspecies that invests in stocks and, accordingly, tends to overtrade."

Recognizing our limited ability to predict the future is an important ingredient of the winning investment strategy. Being aware of the tendency toward overconfidence, you can avoid the mistake of trying to outperform the market. Meir Statman, a finance professor at Santa Clara University, provided the following advice on how to avoid the mistake of overconfidence: "Start keeping a diary. Write down every time you are convinced the market is going to go up or down. After a few years, you will realize that your insights are worth nothing. Once you realize that, it becomes much easier to float on that ocean we call the market."

Chapter Two

MISTAKE 2 Do You Project Recent Trends Indefinitely into the Future?

We've found people tend to buy what has done well recently. But, in fact, studies have shown that they cost themselves money with poorly timed purchases and sales. —Scott Cooley Analyst at Morningstar, St. Louis Post-Dispatch, February 11, 1999

As we age, our long-term memory skills tend to remain strong, while our short-term memory skills erode. Unfortunately, individuals don't benefit from that tendency when it comes to investing. It seems to be a simple human failing to fall prey to recency—the tendency to give too much weight to recent experience and ignore long-term historical evidence. This leads to being overconfident (a mistake we have already identified) and to treating the unlikely as impossible (a mistake we will discuss later).

Consider the following example. From 1990 through 2002, the S&P 500 Index outperformed the MSCI EAFE (Europe, Australasia, and Far East) Index by 8.5 percent per year (9.7 versus 1.2). Why would you invest internationally when you can invest all your money safely in the United States? This led many investors to avoid international stocks. Then from 2003 through 2009, the MSCI EAFE outperformed the S&P 500 by 3.7 percent per year (10.4 versus 6.7).

More recent examples of this phenomenon are the rushes by investors into commodities and into emerging market (especially China) funds after the spectacular returns from 2003 through 2007. In 2008, investors fled as quickly as they entered.

Perhaps the best examples of the dangers of recency are provided by the following studies. Morningstar tracked the performance of the least popular fund categories from 1987 through 2000. It defined popularity by the amount of cash flowing into or out (redemptions) of funds. The least popular funds are those receiving the least amount of inflow or experiencing the most amount of outflow. As it turns out, the three least popular categories of funds have beaten the average fund 75 percent of the time, and more amazingly, they have beaten the most popular funds 90 percent of the time.

The Financial Research Corporation looked at fund flows following the best and the worst four quarters for each of Morningstar's 48 investment categories. What Financial Research found is that investors follow a consistent pattern of buying high and selling low—not exactly a prescription for investment success. In the quarters following high returns, an average of $91 billion in net new cash flowed into funds—investors bought high. On the other hand, after the worst-performing quarters, cash inflows dropped to just $6.5 billion—investors missed out on the opportunity to buy when investments were on sale.

Also consider that during the great bull market of 2009 and through almost all of 2010, investors were pulling money out of U.S. equity funds.

The Cost of Performance Chasing

The returns reported by mutual funds are called time-weighted returns (TWRs), which assume a single investment at the beginning of a period and measure the growth or loss of market value to the end of that period. This is what we can call investment returns. Investors, however, earn dollar-weighted returns (DWRs) that are impacted by the timing of additions and withdrawals. This is what we can call investor returns. And as you will see, the DWRs can differ greatly from the reported TWRs.

Morningstar analysts studied the performance of mutual funds and their investors and found that the returns earned by investors were below the returns of the funds themselves in all 17 fund categories they examined. For example, among large-cap growth funds, the 10-year annualized DWR was 3.4 percent less than the TWR. For mid-cap growth and small-cap growth funds, the underperformance was 2.5 and 3.0 percent, respectively. Even value investors fared poorly, though their underperformance was not as severe. Large-cap value investors underperformed the funds they invested in by 0.4 percent per year, and small-cap value investors underperformed by 2.0 percent per year.

We also have evidence from a study done by the Bogle Financial Markets Center. The sample consisted of the 200 funds with the largest cash inflows for the five-year period 1996 through 2000. The TWRs of the funds and the DWRs of investors in those funds were compared for the 10-year period 1996 through 2005. The average TWR for the 200 mutual funds was 8.9 percent per year. However, the actual DWR earned by investors was just 2.4 percent per year, a gap of 6.5 percent per year. The study also found the TWR exceeded the DWR in all but two of the 200 funds—and there was not a single case where the DWR exceeded the TWR by more than 0.5 percent. Even more shocking was that in the case of 76 funds, the cumulative shortfall ranged from -50 percent to -95 percent.

Even index fund investors are subject to recency. We can see the evidence of this from a Morningstar study that covered the 10-year period ending in 2005. The TWR of no-load index funds was 8.9 percent, 1.8 percent greater than the 7.1 percent DWR earned by investors in these funds.

Summary

Falling prey to recency means trying to buy yesterday's returns. You have to keep in mind that you can only buy tomorrow's returns. This problem can be avoided by ignoring the media, the financial press, and "expert" advice from Wall Street urging you to act on the mistaken assumption that somehow this time it's different. Before jumping on any bandwagon, check the long-term historical evidence and the logic of the conclusions (and watch out for overconfidence). Those who do jump on the bandwagon are likely to be found abandoning it in the near future.

Chapter Three

MISTAKE 3 Do You Believe Events Are More Predictable After the Fact Than Before?

There is an old saying that on Monday morning we all make great quarterbacks. With the benefit of hindsight, the right play to call and the winning strategy are always obvious. Unfortunately, it seems to be a human failing that we are either unable or unwilling to recall what our beliefs were before the events actually occurred. We have a tendency to exaggerate our pre-event estimate of the probability of an event occurring. This hindsight bias may lead us to believe that events even the "experts" failed to foresee were not only painfully obvious but also possibly inevitable. Every day we hear after-the-fact analysis explaining market moves in a way that sounds as if an event were predictable. To demonstrate that this phenomenon is a result of hindsight bias, consider the following:

In the 21 years from 1990 through 2010, the S&P 500 Index outperformed an index of Japanese large-cap stocks by 10 percent per year (8.5 versus -1.5). Although many investors may believe that it was easy to foresee this occurring, let's see just how obvious it actually was.

It's 1989. Japanese asset prices are rising rapidly. The Nikkei is at 40,000, having risen almost 500 percent for the decade, and no top is in sight. Land values have risen so high, the land under the Imperial Palace is worth more than all the real estate in California. The Japanese "managed capitalism" model, with a few government officials deciding how capital will be allocated, is the envy of the world, a model other countries should adopt. Japan is running huge budget and trade surpluses. On the other hand, the United States is running huge budget deficits, the economy is growing slowly, and the market is about to fall again in 1990. Sony's cofounder Akio Morita states:

America no longer makes things; it only takes pleasure in making profits from moving money around. America is by no means lacking in technology. But it does lack the creativity to apply new technologies commercially. This, I believe, is America's biggest problem. On the other hand, it is Japan's strongest point. America assuredly faces gradual decline.

Of course, the world turned out to be quite a different place from what most experts were predicting. At the start of 2011, the Nikkei Index was still down almost 75 percent.

Summary

Hindsight bias is dangerous. It causes investors to recall their successes but not their failures. It also causes investors to believe that investment outcomes are far more predicable than they actually are. Meir Statman put it this way: "Hindsight bias makes it easy to believe not only the future is preordained, but that anyone with half a brain could have seen it."

Hindsight bias promotes both overconfidence and a perception that investing entails less risk than it actually does. This mistake can be avoided by remembering that stock market returns are unpredictable. The best solution to the unpredictability of the market is to build a globally diversified portfolio of index and passive asset class funds that reflects your unique ability, willingness, and need to take risk. Finally, take the advice of columnist Jason Zweig: "Whenever some analyst seems to know what he's talking about, remember that pigs will fly before he'll ever release a full list of his past forecasts, including the bloopers."

(Continues...)



Excerpted from Investment Mistakes Even Smart Investors Make and How to Avoid Them by Larry E. Swedroe RC Balaban Copyright © 2012 by Larry E. Swedroe and RC Balaban. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

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