The Three Biggest Mistakes Investors Make

I’ve been advising clients on money management issues for over 30 years and have experienced many rewarding and challenging market environments.  Over that time I’ve watched investors make three major life-changing mistakes: 

Mistake # 1 – Underestimating the Impact of Losses

Investing is inherently risky and losses can be expected, but it’s important to keep those losses small-to-moderate.  Large losses can do serious damage to long-term performance, even if the market recovers strongly.  
 

• The reason is that long-term investment performance is not a result of simply adding and subtracting annual returns - it is determined by the compounding affect of positive and negative returns on the portfolio over time.  In that reality, losses count more than gains. 
• Portfolio losses, on a percentage basis, have a much greater impact on long-term performance than do gains, so minimizing losses is critical to long-term success. 

• Recovering from a large loss requires a much greater effort because there are fewer dollars remaining to earn a return.  For example, referring to the chart above, a 25% loss requires a 33% gain in order to breakeven.  A 50% loss requires a 100% gain.  Notice that the required return to breakeven accelerates in size as the loss gets bigger, making the road to recovery much more difficult.  In contrast, a 10% loss only requires an 11% return to breakeven.   A 15% loss only requires an 18% return, making a recovery more likely. 
• The attached chart, The Cost of Recovery, from Allianz Global Investors illustrates how the math works and how difficult it is to recover from large percentage losses.  While it covers a specific time period in the recent past, it nevertheless serves as an excellent example.
• Moreover, recovering from a large loss could take many months or even years, putting in complete jeopardy an individual’s or couple’s retirement plans.
• For pre-retirees, large portfolio losses may inhibit the accumulate of sufficient assets for retirement, at a time when they have fewer years to recover.   
• For retirees who are taking income from their portfolios, large losses can be devastating. The required gain to breakeven increases significantly because they have to make up not only for the investment loss but also for the income taken, or else risk early depletion of their portfolio.
  
  For example, in the above chart, a 5% income withdrawal at the beginning of the year, followed by a 25% loss, and then another 5% withdrawal, would require a 51% gain in the second year to breakeven.  A 50% loss would require a 165% gain to breakeven – making it all but impossible to recover.
  
  Even moderate portfolio losses can be especially dangerous for retirees.  A 10% loss would require a 24% return to breakeven in year 2.  A 15% loss needs a 32% return. 
  
  Moreover, if portfolio shares need to be liquidated for income, those shares are no longer available for recovery.  Consequently, the loss is not just a price decline, but also a loss of assets, and the impact on the portfolio is permanent.  The danger is that a continued erosion of the asset base over time may send the portfolio into a irrecoverable downward spiral and significantly increase the likelihood of running out of money.

The bottom line for all investors: Big losses are much more disastrous to long-term performance than sizable gains are beneficial. The lesson is to have a strategy in place that seeks to minimize losses when market downturns occur.

 
Mistake # 2 - Failing to See the “Big Picture”

Historically, the "Big Picture" looks like this:

• The stock market moves in long-term trends that typically last 10 to 20 years, producing long periods of upward trending markets and high returns, referred to as secular bull markets; followed by long periods of a sideways or downward trending markets and low returns, referred to as secular bear markets.  Please refer to the enclosed chart from Rydex|SGI showing The Dow Jones Historical Trends for the past 113 years. 
• Overall the stock market has rewarded investors with long-term growth, but that growth has not come evenly. The Rydex|SGI chart shows that, over the last 113 years, there have been four secular bull markets and four secular bear markets, each lasting approximately 17 years on average. 
• As you can see, during secular bull markets and secular bear markets investment returns differ dramatically! 
• If you were lucky enough to have spent most of your investment/retirement life in a secular bull market, then you were very fortunate.  Market index returns were, for the most part, generous and plentiful.  If, on the other hand, you were unlucky to find yourself investing/retiring during a secular bear market, as we have now, then you need to fight for and protect every return you get.

Understanding this reality is essential in order to plan an intelligent investment strategy.

Mistake # 3 - Not Adapting to Change

In order to be successful, you have to adopt to change and match your investment strategy to the market environment. 

• During secular bull markets, when markets generally rise, a “buy-and-hold” approach to investing generally produces excellent returns.  That certainly was the case from 1982-2000.  According to the Rydex|SGI chart, the Dow Jones Industrial Average generated a tremendous cumulative return of 1003.19%.
• However, during secular bear markets, when powerful rallies and declines tend to cancel each other out over time, such a strategy may produce little or no return.  A recent example of that is what happened during the “Lost Decade” of 2000-2009.  According to the Rydex|SGI chart, the Dow Jones Industrial Average generated a dismal ten-year cumulative return of - 4.68%. 
• Secular bear markets are characterized by extreme volatility and have more frequent and more severe market declines than do secular bull markets.  Gains tend to be temporary.  Also, because economic growth is fragile, the economy tends to experience multiple recessions over the years, as it vacillate above and below zero growth.
• The current secular bear market is not a result of an overheating, inflationary economy that needed to be cooled off with higher interest rates, as has been the case with the typical post-WW II business cycle.  Instead, it is a result of excessive debt accumulation and falling asset prices.  Such “deflationary” secular bear markets are much more difficult to grow out of.  The last one in the U.S. occurred during the Great Depression.  A more recent one has been taking place in Japan since 1989 to present – 22 years and counting.  
• Investing in a such a environment requires an investment strategy that is more flexible to take advantage of profitable opportunities when they occur, and, more importantly, is much more responsive to managing risk, so that capital is preserved and gains do not disappear in the next downturn.

I have long been an advocate that we have been in a secular bear market since the year 2000.  This trend is likely to last several more years due to a number of very difficult economic challenges facing our country. 

Please read the section on Economic and Stock Market Headwinds for more perspective.

The “New Normal”

According to Pacific Investment management Company, PIMCO, a highly regarded investment management firm, the global economy and financial markets have entered a period of fundamental transformation that it refers to as the “New Normal”. 

The New Normal is characterized by greater government regulation, consumer deleveraging (i.e., paying off debt and increasing savings), persistently high unemployment, an extended period of below–average economic growth in the developed world, and below-average investment returns. 

In addition, the explosion in the size and growth of government debt worldwide has added an acute level of risk to the global economy and financial markets.

There is a concern about whether the private economy can grow without continued government intervention. 

After the most massive monetary and fiscal stimulus ever applied to a major economy, U.S economic growth is fragile and tepid, and well below prior recoveries.  The Federal government may be running out of stimulus bullets. 

The enormous fiscal spending on bailouts, transfer payments to states, "cash for clunkers", housing tax credits, construction projects, and social programs is now tapering off.  Left behind are extraordinary high levels of debts. 

In addition, the Federal Reserve Board’s gigantic monetary stimulus has had little effect.  Record low interest and mortgage rates have not invigorated the economy and the housing market as expected. 

Moreover, there is a growing backlash against more borrowing and spending as citizens increasingly voice their concerns, and political pressure mounts in Congress to curb spending.

A big question remains.  Once the extrodinary governemntal responses are exhausted, if slow growth persists or if the economy falls into another recession, what options are left to stimulate the economy?   More of he same?  Something different?  With what consequences?  Whatever options will be tried will be unprescentent and without the benefit of experience or proven economic models.

PIMCO summarizes its outlook:

 “The world is on a bumpy journey to an unstable destination, trough unfamiliar territory,
 on an uneven road, having critically already used its spare tire(s).”

I welcome your comments and inquiries.

“Helping you Build, Protect and Sustain the Lifestyle you Want”

The opinions expressed in this material are for general information purposes only and are not intended to provide specific advice or recommendations for an individual.

Copyright © 2010 Jeffrey M. Stark, CFP®