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Investing Specialists

Common Investor Mistakes

Morningstar StockInvestor editor Matt Coffina discusses a few of the pitfalls that cause many investors to underperform the market.

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A version of the following article appeared in the October issue of Morningstar StockInvestor. Download a complimentary copy of StockInvestor here.

During the past decade, large-cap mutual funds have underperformed the S&P 500 by 60 to 100 basis points per year, depending on the category. Even worse, according to Morningstar's mutual fund data, investors have underperformed the mutual funds they invest in by around a percentage point per year because of poorly timed purchases and sales. It is with good reason that some of the most sensible investors--Vanguard founder Jack Bogle chief among them--recommend buying and holding low-cost index funds. We should never underestimate how difficult it is to beat the market over long stretches of time.

On the other hand, the track record of Morningstar StockInvestor's Tortoise and Hare portfolios clearly demonstrates that it is possible to outperform the market. On a combined basis, our real-money portfolios have delivered a total return of 179.5% since our June 2001 inception, beating the S&P 500's 76.4% by 103 percentage points cumulatively, or 4 percentage points per year.*

Just as importantly, we didn't take on excess risk to achieve this result. Our beta since inception has been 0.88 (a figure below 1.00 indicates that a portfolio's fluctuations tend to be less severe than those of the market). The annualized standard deviation of our returns has been 14.2%, below the S&P 500's 15.3%. Perhaps most significant, we've experienced our greatest outperformance during bear markets. The S&P 500 has delivered a negative total return in three years since our inception--2001, 2002, and 2008--and the combined total return for the Tortoise and Hare was about 10 percentage points better than the benchmark in each of those years.

Of course, past performance is no guarantee of future results. Below, I discuss a few of the most common mistakes that cause investors to consistently lag the market. The first step in our quest to continue outperforming is to avoid these pitfalls.

Focusing on Stock Prices Instead of Intrinsic Value
Stock prices move for all sorts of reasons in the short run, many of which have little to do with the fundamentals of the underlying businesses. This was never more clearly on display than during the financial crisis in late 2008 and early 2009. Shares of high-quality businesses with plentiful free cash flow, rock-solid balance sheets, and little direct connection to the turmoil in the housing or financial markets sold off alongside everything else. For example, both Google (GOOG) and Coca-Cola (KO) were down more than 40% from prior peaks during this period.

Amid the worst of the financial crisis, the median stock in our coverage universe was trading at an incredible 45% discount to our fair value estimate, and more than 850 stocks earned a Morningstar Rating for stocks of 5 stars. Within five years, the S&P 500 was up more than 150% from the lows and stocks had appreciated back to intrinsic value (and then some), on average. For many investors, living through the 2008-09 financial crisis was like torture. However, if you happened to move to a desolate part of Siberia in 2007 and neglected to check your portfolio for six years, it would almost seem as if the financial crisis had never happened (though returns during this period might still make you wonder why you left the tundra).

The first lesson here is that we should never allocate funds that we will need in the next five years to common stocks. It is hard enough to maintain composure during a market decline even if you don't need to make withdrawals. But if your sinking portfolio means you may not be able to buy a house, send a kid to college, or retire when you expected, staying rational through a bear market could prove impossible.

If you need a certain amount of money in the near term, do yourself a favor and keep those funds in short-term bonds, money market funds, bank deposits, or the like.

The second lesson is that stock price movements tell us next to nothing on their own. What we really care about is intrinsic value: What is this company worth, based on its ability to generate cash flows in the future? This usually isn't easy to answer--Morningstar's approximately 100 equity analysts spend a significant portion of their time building and updating their valuation models. Nevertheless, this is where our focus should be. If we can identify reasonably priced companies that are likely to compound their intrinsic values over time, attractive total returns will eventually follow. Ben Graham's weighing machine always wins out over Mr. Market's voting machine in the long run.

Trying to Time the Market
This is probably the biggest reason individuals tend to underperform the mutual funds they invest in. Everyone hopes to buy stocks when the market is low, and sell them when the market is high. Unfortunately, I'm not aware of anyone who can do this with any consistency. Instead, most investors who try to time the market end up buying high and selling low.

There are rare occasions when the market gives clear signals that it is either massively undervalued or overvalued. In late 1999, experienced investors recognized that stock valuations had become completely disconnected from reality, especially among technology stocks. In late 2008 and early 2009, it was fairly obvious that most stocks were very cheap in any scenario other than a complete meltdown of the global economy.

However, the market's valuation is usually far more ambiguous. Astute observers might have noticed the trouble brewing in the mortgage market in 2007, but few predicted the severity of the subsequent crash. The market's signals in 2013 are even less clear. Collectively, our analysts think the market is a bit overvalued--the median stock in our coverage universe is trading at a price/fair value ratio of 1.05--and P/E ratios are about in line with or slightly above long-term historical averages. Some investors believe that we are still in the early stages of economic recovery, with significant pent-up demand and underutilized capacity that will drive robust growth in the coming years. Others argue that profit margins are at unsustainable highs, P/E ratios are inflated if you use a longer-term average of earnings, and the market is only being held afloat by the Federal Reserve's exceedingly loose monetary policy.

It made sense to raise cash in 1999 and to double down on stocks in 2009. However, in most circumstances I think it is folly to try to guess at the market's highs and lows. I will readily admit that I have no idea whether stocks will be higher next week, next month, or next year than they are today--and if anyone tells you otherwise, I recommend you hold on to your wallet. On the other hand, I have a high degree of conviction that stock prices will eventually converge toward their intrinsic values. Our efforts are best spent studying the intrinsic value of individual companies, rather than trying to divine the next wiggle on a stock chart.

Failing to Think Probabilistically
This brings me to my last point--the importance of thinking in terms of probabilities. In baseball, you can fail to get a hit more than 60% of the time and still be the best batter in the league. In poker, you can have a full house and lose to a hand with four of a kind. Yet for some reason, many investors seem to expect that their stock picks will work out every single time and that their path will be a straight line up from the investor's purchase price.

The reality is that the business world is full of uncertainty. Despite our best efforts, things will happen that we can't hope to foretell: commodity price swings, technological advances, shifts in consumer preferences, emergence of new competitors, regulatory changes, and so on. The good news is that we don't have to be right 100% of the time to end up with a very satisfactory result. There have been plenty of mistakes in the history of the Tortoise and Hare, but they have been far outweighed by our successes.

Every investment has both a bull case and a bear case. Our job is not to focus on one side or the other, but rather to understand both the positives and negatives, estimate what is already incorporated in stock prices, and determine where the opportunities lie.

* Performance through Sept. 30. Total returns include reinvested dividends.

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Matthew Coffina has a position in the following securities mentioned above: KO. Find out about Morningstar’s editorial policies.