In an exclusive excerpt from his new book How Not to Invest, Barry Ritholtz offers some friendly reminders about how easy it is to make money-losing decisions.
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Decades as an investor and trader on Wall Street have taught me that market panics come and go. Geopolitics, inflation and profit warnings, among other variables, can make a mess of things — and the ensuing volatility often fuels our urge to make a decision, any decision. Especially the bad kind.
How investors respond to market turmoil is, of course, what behavioral finance is all about. And, just like in baseball, what you want to avoid are unforced errors, which have a tendency to contribute to long-term financial harm. There’s an endless assortment of ways to make mistakes that hurt your portfolio, though most fall into four broad categories: believing things that are not true; attempting to operate outside of your skill set; allowing your behavior to be driven by emotions; and failing to let time work for you.
The bottom line is, whether you’re an ordinary investor or a billionaire, even modest mistakes can lead to monumentally bad outcomes. The trick to avoiding pitfalls, no matter how much money you have? Don’t try to score more wins. Just try to make fewer errors.
Don’t Show Up Late to the Party
Chasing a well-performing stock can cause you to buy high and sell low, and then repeat until you’ve learned your lesson. You see this all the time: After a run of spectacular gains, the media fêtes a ticker or a manager, and buyers show up — late and en masse. The inevitable mean-reversion soon follows.
One recent example of this phenomenon is the ARK Innovation ETF (ARKK), managed by Cathie Woods, which had one of the best runs of any fund ever. For the 2020 calendar year, the fund gained 153%; from the pandemic lows in March 2020 to its peak 11 months later, ARKK’s returns were an eye-popping 359%. Recognition and huge inflows soon followed.
Therein lay the behavior gap: Most investors bought ARKK after its epic run. For those unfortunate ARKK investors who bought the stock at its 2021 peak of nearly $160 a share, the price dropped more than 80% to less than $30 at its lowest point at the end of 2022; today, it’s trading at about $50 a share. Those triple-digit returns investors dreamed of look rather distant now. Investors who entered the game five years ago, before ARKK’s run, saw only a 1% return. For ARKK investors who bought three years ago, it’s even bleaker: Their average annual return was -7%, according to Morningstar data.
Trick Your Lizard Brain
Nobel laureate Paul Samuelson once said, “Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” While the dopamine hit that comes from a risky stock bet paying off may be enjoyable, passive management is the better option for most investors looking to grow long-term wealth.
The catch is that you must take steps to protect yourself from, well, yourself. To do so, set up a “mad-money account” — or a cowboy account, as it’s sometimes called. Add less than 5% of your liquid capital, so maybe $5,000 if you’re liquid enough to have $100,000 as a safety net. Now you can indulge your inner hedge fund manager without jeopardizing anything too material.
If it works out, you’re more likely to let those winners run because it’s for fun and not your real money. If it’s a debacle, appreciate the terrific lesson that should remind you that this is not your forte.
Hedge Your Bets
What should you do when you’re fortunate enough to receive enormous, life-changing wealth? It doesn’t matter if it is Nvidia, Bitcoin, founder’s stock, or an employee stock option purchase plan (ESOP) — sometimes the market goes wild and the sheer size of a yield is staggering.
But what should you do? Sell? Hold? Buy more?
Try employing a regret minimization framework. Ask yourself, How would you feel if a) you held and the stock tumbled or b) you sold and it soared?
Playing it safe is never a bad bet. The truth is that we have no idea where prices will be in the future and selling could net a windfall that can be life-changing for you and your family.
If you are sitting on a massive windfall, remember too that it doesn’t have to be an all-or-nothing decision. The middle option is to sell enough to become wealthy, leaving you with plenty of upside if prices do rise in the future while protecting you from lifelong regret in the unexpected case of a dotcom-like collapse.
Stop Chasing Yield
In the low-yield environment of the past quarter-century, there have been three common yield mistakes: buying longer-duration bonds; acquiring riskier, low-rated junk bonds; or using leverage to amplify your gains. All of these strategies have sounded good on occasion; they’ve also helped a lot of smart people lose a ton of money. Especially leverage.
The key error investors can make is not remembering that risk and reward are two sides of the same coin. If you want more yield and you pursue riskier outcomes, you increase the chance that you not only won’t get the higher yield, but you also may not get your principal back.
Few mistakes have been more costly than “chasing yield.” Just ask the folks who loaded up on securitized subprime mortgages before the housing crash, which were originally marketed as “AAA-rated, safe as Treasuries, but yielding 200-300 basis points more” — a potent reminder that even the savviest investors can trip over their own feet in pursuit of a market win.
Barry Ritholtz is the host of Bloomberg’sMasters in Businesspodcast. He is chairman and chief investment officer of Ritholtz Wealth Management, and was previously chief market strategist at Maxim Group. Adapted fromHow Not To Invest: The Ideas, Numbers, and Behaviors That Destroy Wealth — and How to Avoid Them, published by Harriman House.
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