Being competent requires avoiding major mistakes. Yet I see time and time again investors making basic errors while spending a lot of time and effort trying to beat the market. That's like trying to join the NBA without knowing how to dribble the ball--the only difference is the NBA won't let you play, even if you show up to a game wearing a jersey and carrying a bagful of cash. The finance industry and its satellites, on the other hand, are more than happy to take your money.
I believe there are three major types of mistakes investors make.
Mistake I: Failing to understand and manage one's limitations
It's understood that for every trade there is a winner and a loser. Some mistake this to mean that beating the market is simply a matter of being in the top half of investors--not a high hurdle. Slightly more knowledgeable investors realize that transaction costs are involved, so they move the hurdle up to top third or top quartile. What many investors fail to realize is that skilled investors control a disproportionate share of capital. Because each rupee of outperformance must be offset by a rupee of underperformance, each skilled investor must be offset by many unskilled investors. Put another way, for every Warren Buffett, there are the many losers who stood on the other side of his trades, selling him things he bought, buying the things he sold.
This should scare any beginner. The hurdle is high. Even though I live and breathe investments, I worry about my own ignorance all the time. I know for a fact I have lots of wrong beliefs rattling in my head. The best I can do is to be conscious of this fact and try to root them out. The things I'm very confident in are precious few, and much of it composed of the knowledge of what I know I'm not good at. (If you can't identify many things you're bad at, you're probably overconfident.)
Of course, most investors try to hire someone who does know what they're doing. They hire people like Bill Gross, co-founder of Pacific Investment Management, to anticipate major central-bank policy shifts and Bruce Berkowitz, equity fund manager and founder of Fairholme Capital Management, to pick stocks. At least they think that's what they're doing. Most investors have been dragooned into the portfolio manager role, because the most important decision is really the allocation between stocks and bonds, and how that allocation evolves over time. That's a lever most investors keep firmly in their grasp.
Most investors make a hash of it, so much so that the standard financial advice is to keep one's stock/bond allocation static. It's good advice, to be discarded only after you become justifiably confident in your process. Even then, you might still be wrong. The way to render mistakes as harmless as possible is to keep fees as low as possible and portfolios diversified.
Mistake II: Failing to understand incentives
Many investors are naive when it comes to money. They believe that there are services and individuals out there desperate to offer any comers high returns and low risk.
Analyzing incentives is critical. It's a natural consequence of managing one's limitations. Investing will always involve dealing with people who know far more than you. One of the best ways to manage this problem is to understand how the people and firms offering your services are compensated. Good investors understand the importance of agency costs. If you look at stock analyses conducted by top hedge fund managers, one of the core questions they try to answer is how the firm's C-suite is given incentives to do the right thing.
Some cynics say that most peoples' main incentive is money. While there's a large grain of truth to that, I know for a fact that money isn't everything or even the most important thing. People care about other things, such as respect, autonomy, or even that warm feeling resulting from helping others. I know people who are smarter, more accomplished, and harder-working than me making far less money, because they have nonpecuniary goals. Everyone's different in their wants. When it comes to money it's almost never a good idea to put your trust in the hands of someone who cares only about getting more of it. If they know more than you, are smarter than you, they will get their hands on it some way or another. Warren Buffett himself says that the most important quality in a money manager is ethics.
Mistake III: Failing to understanding the basics
Defying common sense, some investors believe that they can be very successful without having a deep base of knowledge, as if ignorance were a badge of honor. The best you can reasonably expect with a weak grasp of the basics is to get lucky--either you put your money in the hands of someone who happens to be good, or you get lucky yourself and own things that go up in value.
There are certain concepts that an investor must understand to do a passable job investing. One is statistics and probability. An advanced level of knowledge isn't required, but it is essential to have an intuitive understanding that investing is a statistical exercise, where the luck of the draw dominates day-to-day, even year-to-year outcomes. Without feeling and knowing this fact down to your toes, you're liable to do silly things like react to noise generated by the market.
The other important topics include financial history, the incredible difficulty of forecasting the future, the ways humans are wired to misbehave, and so forth. I'm not going to go over them all. Needless to say, the basics encompass a body of knowledge that's at least book-length. If you're shaky, please buy a good book. I recommend "The Investor's Manifesto" by William Bernstein. Bernstein is even more of a curmudgeon than I am and is actually somewhat distrustful of exchange-traded funds.
Samuel Lee is a strategist on the passive funds research team for Morningstar. This article originally appeared on Morningstar U.S. and has been edited to make it applicable to an Indian audience.
