By Aleksandra Todorova
To err is human, but when it comes to investing, mistakes can be costly. A third of everyday investors had zero or negative returns in 2014, according to an analysis of the portfolios of more than a quarter million investors by investment firm SigFig. In a year that saw the Standard & Poor's 500 index surge 13.6 percent, the median investor's portfolio rose just 4.2 percent.
Ironically, many investors make mistakes because they're trying to beat the market, and more importantly, because they think they can, says Harold Evensky, chairman of Evensky & Katz wealth management firm and professor of practice at Texas Tech University.
At speaking engagements or lectures, Evensky often asks his audience to raise hands if they think their children or grandchildren are better than average. Typically, everyone does. "Statistically, that can't be," Evensky says. "But it's classic behavior. People don't like the idea of being average." It is in that pursuit of better-than-average performance that investors often fall into one or more traps that may hurt their portfolios in the long run:
Six in 10 investors have more than 10 percent of their portfolios invested in a single stock, according to an analysis by SigFig. Moreover, 15 percent of investors have more than half of their portfolios invested in just two stocks.
Many of these investors work (or worked) for a company with a generous employee stock discount program, or one that distributes bonuses in the form of company stock. Alternatively, shares the investor purchased years ago may have appreciated so much that they have thrown their overall asset allocation out of whack. The horror stories of Enron and Washington Mutual employees should provide a sufficient reminder that single-stock concentration exposes investors to excessive risk that can jeopardize their financial future.
Pride in one's home country is patriotic, but letting that patriotism undermine one's investment strategy is ill-advised. Evensky recalls assembling a portfolio for a potential client, who then banged his fist on the desk and stormed out of the office when he saw that a sizable portion would be invested in international funds. "Forget it," the client said. "I'll never invest a penny outside of the United States."
The example may be extreme, but the mistake is common. For 60 percent of investors in SigFig's analysis, international equities represented less than 10 percent of their equity portfolio. At the end 2013, U.S. investors held, on average, 27 percent of their total equity allocation in international funds, according to Vanguard (citing Morningstar data), even though non-U.S. equities accounted for 51 percent of the global stock market. While no one answer fits all, Vanguard recommends "a reasonable starting allocation to non-U.S. stocks of 20 percent, with an upper limit based on global market capitalization."
Paying More for "Better Returns"
With 1,411 exchange-traded funds available at the end of 2014, according to the Investment Company Institute, investors have plenty of options to choose from to build a well-diversified, low-cost portfolio. How low can low-cost go? According to SigFig data, investors paid, on average, 17 basis points for ETFs, with popular ones like State Street's SPDR S&P 500 Trust (SPY) and Vanguard's Total Stock Market Index (VTI) charging 0.09 percent and 0.05 percent, respectively.
However, six in 10 investors represented in SigFig's analysis own at least one fund with an expense ratio of 0.50 percent or higher. "They're buying a good story," Evensky explains. Investors who, in effect, pay a professional to beat the market are doing it because they don't want to feel that they're doing average investing. "They buy the Kool-Aid. The stories of very smart people using technology and research that's going to beat the system," he says.
Study after study has shown that more expensive, actively managed funds do not outperform lower-cost index funds over the long run, even during bear markets. Simply put, paying more doesn't guarantee better returns. So why do it?
Overtrading and/or Timing the Market
More than a decade has passed since University of California – Davis professors Brad Barber and Terrance Odean published their now widely referenced study with the catchy title, "Trading is Hazardous to Your Wealth." Its conclusion -- that frequent trading is associated with lower returns -- holds true today. In a recent analysis, SigFig found that each 100 percent of portfolio turnover (that is, selling all holdings in one's portfolio and buying new ones -- which one in five investors do, the data shows) corresponds to a 50 basis-point decrease in returns.
Even a conservative example shows how much of an impact those extra 50 basis points per year could have over the long term. If you save $10,000 a year for retirement and average a 6 percent annualized return, that total would grow to $816,044 after 30 years. If we reduce that annualized return by 50 basis points to 5.5 percent, you would end up with $70,000 less.
Would you give up a year's worth of retirement living expenses (or more) in the pursuit of better-than-average returns? "We try to educate our clients upfront that we're not always going to beat the market," says Evensky, whose firm manages $1.5 billion. "Our goal is to be in-between, and if we can do as well [as the market] and minimize taxes and expenses, we've done our job right." It's a goal worth pursuing, whether you work with a financial advisor or manage your investments yourself.
Aleksandra Todorova is a blogger for The Smarter Investor and editorial director at SigFig.
By Aleksandra Todorova