As the late value investor Benjamin Graham once said: "The investor's chief problem – and even his worst enemy – is likely to be himself."
Last week, I discussed several simple steps investors can take to increase their odds of becoming wealthy over the long run. Today, in the second instalment of a two-part series, I'll look at the bad habits that can sabotage an investing plan.
Mr. Graham definitely had a point. My portfolio has suffered lots of self-inflicted wounds over the years and I've seen plenty of other people make similar mistakes. The good news is that, by becoming aware of common emotional and behavioural pitfalls, you can drastically reduce the frequency of these errors and greatly enhance your returns.
Part of the problem is that humans aren't hard-wired to be good at investing – just the opposite, in fact. For example, instead of buying when stock prices have tumbled – a strategy that pays off in the long run – people often sell because it's the quickest way to avoid the perceived danger and unpleasant emotions that accompany a bear market.
Here are some other common investing bad habits and tips on how to curtail them.
Selling too early
As I was preparing to write this column, I remembered a conversation I had with a friend probably 20 years ago. He held a few hundred shares of Bank of Montreal at the time and was wondering if he should sell them. Why? Because they had run up in price and he wanted to lock in his profit. This kind of short-term thinking can be poisonous to your portfolio. I don't know what my friend decided to do, but I hope he held on to his shares because over the past 20 years, BMO has posted a total return – assuming all dividends were reinvested – of 873 per cent. If you own a solid, reasonably priced company whose revenues, earnings and dividends are rising, hanging on is usually the best option. It keeps your trading costs down, avoids capital gains tax and lets you participate in the company's long-term growth. It's also less stressful than selling and then having to decide how to reinvest the proceeds.
Looking for the big score
Whether it's a gold miner supposedly on the verge of a huge discovery or a biotech startup trying to develop a breakthrough drug, the stock market is full of compelling stories that get investors salivating. That's because these sorts of stocks hold out the hope of a huge profit in a short period of time. But, like a lottery ticket or a trip to the casino, high-risk stocks usually don't pan out. Instead of trying to get rich overnight, you are far more likely to build wealth by investing in established, profitable companies – or diversified funds – and patiently waiting as their dividends and share prices grow gradually over time. I call this the get-rich-slowly approach and I have seen it work for countless individuals.
Taking too little risk
The flipside of looking for the big score is refusing to take any risk at all. We all know people who won't invest in anything but bonds or guaranteed investment certificates. While it may make them feel warm and cozy in the short run, in the long run, it condemns them to sub-par returns. The truth is, if you invest in high-quality companies or funds (see my Strategy Lab model dividend portfolio at tgam.ca/divportfolio for examples) you don't actually have to take a lot of risk to build wealth. However, you do need to learn how to live with short-term volatility – something you can't avoid if you want your money to grow.
Letting someone else do everything
Some people aren't comfortable making investment decisions. I get it. But if you blindly follow your adviser's recommendations, you are exposing yourself to potential trouble. Some – not all – commissioned advisers will put you into inappropriate securities or trade frequently if it means more money for them and their firm. That's why, whether you work with an adviser or on your own, you need to protect yourself by learning as much as possible about investing. You and your adviser should also develop an investment policy statement that specifies your target asset allocation, risk tolerance, financial goals, rationale for changes to the portfolio and other factors. Another way to reduce potential conflicts of interest is to work with a licensed portfolio manager who charges a flat fee based on your assets instead of getting paid through commissions.
Straying from your strategy
There will always be stocks – lots of them – that produce bigger returns than the ones you own. Don't let this cause you to question your strategy. One of the worst things you can do is switch horses frequently in the hope of riding a big winner. By committing to your strategy and controlling the impulses that can push you off course, you will ultimately achieve success as an investor and build lasting wealth.