Not Your Average Investor

On May 31^st 2012, thanks to twitter, worlds literally collided.  Well at least metaphorically speaking.   Well known Canadian rap artist Drake shared this tweet with his 7.2 million followers:

The first million is the hardest.

— Drizzy (@Drake) May 30, 2012

This sparked the following twitter response from T. Boone Pickens:

The first billion is a helluva lot harder RT @Drake: The first million is the hardest.

— T. Boone Pickens (@boonepickens) May 31, 2012

The irony of the exchange is that before social media existed it would be hard to imagine a collision of this magnitude between a pop culture superstar and an energy investing genius.  Yet thanks to the so called twittersphere we have perhaps the strongest example of why social media makes our world a little smaller.

Hidden in this twitter exchange, however, is that Drake and T. Boone are actually much more alike than probably the combined 7.5 million that follow the two of them.  How?  They both have well above average economic means.  One result of this is that their investment choices are far different than the average Joe, who is simply working hard to provide for his family, while trying to put a little aside for the seemingly inconceivable notion of not working one day.  For Drake and T. Boone investment risk means something all together different than it does for the Family of four that has a combined income of say $75,000 per year.  Unfortunately average investors are making the same five mistakes again and again when managing their long term savings portfolio.

So while these tips might not turn you into Drake or T. Boone overnight, they just may very well help you map out a plan that gives you greater certainty about your retirement years.

The Average Investor’s Top Five Mistakes

Average Investor  Mistake #1- Buying High and Selling Low: 

In theory, everyone knows the way to make money is to buy low and sell high but it isn’t so easy to do in practice. One problem is “sentiment” as the price of a stock rises it actually becomes more more attractive to the average investor. Rather than thinking, “this stock has already risen so much it must be near the top”, the average investor thinks “look it’s going up it must be a good stock”. Legendary value investor Warren Buffett has made billions by looking for stock bargains and buying low.

Average Investor  Mistake #2- Not Understanding Their Investments:

Both Drake and T. Boone are experts in their field.  T. Boone grew up around the oil business. His father was in the oil business, and his mother ran the Office of Price Administration during World War II, rationing gasoline and other goods for four counties. So Boone lived and breathed oil. When he went to college he majored in geology, his first job was with Phillips Petroleum Co. By understanding the direction of oil prices he has been able to make extremely large bets on the direction of oil prices. According to his website Pickens Plan…

Boone frequently utilizes his wealth of experience in the oil and gas industry in the evaluation of potential equity investments and energy sector themes. He has not been shy in predicting oil and gas prices and has been uncannily accurate.

So the 2nd biggest mistake the average investor makes is investing in things he doesn’t understand and hoping to beat the experts.

Average Investor  Mistake #3- Not Limiting Losses

That’s all well and good for T.Boone but it only works if you are rarely wrong. If you are not an expert in any field you need to limit risk. If you only have a small nest-egg you have to protect it very carefully and avoid losses. The best way is through diversification. This means not putting more than 1% or 2% at risk at any one time.  That doesn’t mean you can’t put more than 2% into a single stock just that you need to limit your losses to less than 2%. In other words, if you own 10 stocks and 10% of your money is in each of them, if one of them goes to zero you have lost 10% of your money. However, if it loses 50% you have lost 5% and so you would have to limit your losses to 20% on any single stock. But that is assuming you only have one stock going down at a time. If the entire market is collapsing you would have to get out much sooner.  Diversification is more than buying several different stocks you must also be sure you are diversified over industries and asset classes. Van Tharp has an excellent book entitled Trade Your Way to Financial Freedom that shows the how and why of limiting risk in the average investor’s portfolio.

Average Investor  Mistake #4- No diversification/Swinging for the Fences:   How many times have you heard that story at a cocktail party or summer barbeque about the friend of your friend who scored a huge haul on some no name stock that his brother’s sister-in law told him about.  A great story, but what most don’t realize is that for every home run there are about ten times as many strikeouts.  But no one wants to share their story of loss, so they just are not discussed.  The mistake is that too many investors are impatient and are constantly looking to hit the investment home-run.  The problem with swinging for the fences is the amount of risk that comes with it. Lets suppose that your winner is up 1000% that sounds like a pretty big winner. That means that it increased by 10 times which means that it is currently 11 times bigger than when you bought it (remember it was at 1x when you bought it).  So you think oh if I had only invested $1000 in that one I’d be rich. But would you? If you had invested $1000 and it went up 1000% it would be worth 11 times what you paid for it or $11,000. A nice percentage gain but not enough to make you rich. But what if you invested your entire nest egg? Then you would be doing well but that means violating rule number 3. What if instead of increasing 10x it had fallen by 50%? You would have lost 50% of your nest-egg and your investment strategy would be set back considerably.

It is a losing strategy.  Investors should seek a fair rate of return and proper diversification not swing for a mammoth haul every time they pick a fund or stock.

Average Investor  Mistake #5- Underestimating Tax in Retirement Years:

As amazing as this may sound too few actually understand that their tax qualified plans are going to have significant tax burden as soon as funds are withdrawn.  The average investor must seriously consider his retirement distribution plan and factor in realistic tax rates and possible medical expense.  This provides greater clarity over the lifestyle they can expect to lead when their working days are done.

The good news is that every one of these mistakes is avoidable and easily addressed.  Many times with no changes to cash flow at all.  So take a minute to evaluate your current long term savings plan and determine if you are falling into any of these common investment pitfalls.  Hopefully you are not, but if you are just remember what Drake and T. Boone have to say – the first <insert a realistic for you amount of money here> is the hardest.

For more information See:

Trade Your Way to Financial Freedom by Van Tharp

Also See:

• The Wealthy Buy Assets, the Poor Buy Liabilities, and the Middle Class Buy Liabilities Believing They Are Assets
• Investing better than Average

Photo credit: opensourceway