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What Behavioral Mistakes Are Investors Making Today?

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

As part of our special report on investor behavior, we sat down with three Morningstar strategists--Sam Lee, Josh Peters, and Russ Kinnel--to get their take on the biggest behavioral mistakes investors are making. Here is what they had to say.

Sam Lee: Number one thing is overconfidence, and overconfidence leads to a lot of things. It leads to investors taking on way too much risk. It leads investors to turn their portfolio--that is, incur a lot of taxable gains in the pursuit of better opportunities. And those things are really devastating to most investors' portfolios. I think a low-turnover strategy that's low cost, very tax efficient is probably the best way most investors should go. And you require a lot of skill and a lot of understanding before you are actually capable of moving beyond that in an intelligent way.

People are overconfident in terms of their own stock-picking skills. They don't really understand the role of luck. And if you look at every single statistically rigorous study, that study shows that skill only leads to very, very small gains for very, very skilled people. And in general, people who are making 10%-20% above the market are most likely lucky, not skilled. So you can't expect 10% above the market returns. If you're pretty skilled, you can reasonably expect maybe 2% or 3% [above the market].

Josh Peters: I think for people who are looking for income, the biggest mistake he can make is listen to the current Wall Street received wisdom, which is that the dividend trade is over. It amazes me how quickly people will seize on this idea that you only buy high-yielding stocks if the economy is getting worse or if interest rates are going down, and then you bolt and you sell these great companies with their great dividend yields as soon as times get better or interest rates go up. That's not what these stocks are about.

These stocks are not, in fact, at all about Wall Street; they're about you, because you're getting your cash earnings directly from the company through those dividend payments. These companies can help you meet your financial objectives whether you're beating the market right now in this current month or current year, or not.

And over the last 8 1/2 years, I've actually made it an explicit promise that I am not trying to beat the market on its own terms. I am not shifting my portfolio and rotating between different stocks and sectors trying to beat the market every year, but by not trying, by just focusing on the income that we're collecting and the growth of that income mostly through dividend increases over time, we've managed to beat the S&P by a pretty wide margin.

That is, I think, the kind of outperformance that you can actually put in your pocket and spend. So, what you want to do is stay away from this idea that it's a competition, that somehow investing is a game you're playing against other people that you have to win. It's a journey and the destination is actually being able to meet your financial goals.

Russ Kinnel: Well, one of the biggest ones they make is trying to make macro bets. John Rekenthaler actually looked at the gap between fund returns and investor returns. He broke it down by asset calls and individual fund choices. He found [investors] are actually picking pretty good funds, but they do a really bad job of making asset class calls. And I think part of that stems from just watching too much of the TV news cycle, where you really can get worked up and think, oh this trend is going to go for a long time. You get worried about the U.S. government or you get worried about real estate or whatever, and you overreact and you don't realize that all of that is already priced into the market, and instead you should be focusing on your plan and what works for your long-term goals.

Glaser: But have these investor mistakes created any opportunities? We also asked the strategists if they've seen any mispricing or attractively priced securities in the market because of these bad behaviors.

Lee: Well, I don't really know. I wouldn't go out and say this is mispriced, because if I knew I would be shorting that or going long that and making a lot of money.

But I would say that one thing that overconfidence leads investors to do is to invest in exotic securities or products that they don't really understand. A good example is the VIX ETNs that are out there. VIX ETNs suffer from monthly roll costs. They lose about 5% to 10% every month like clockwork. Occasionally they spike up when volatility spikes, and investors who are buying into the VIX have lost a ton of money. In aggregate, the VIX products have probably destroyed tens of billions of dollars of investor capital, and a lot of it is probably from individual investors. So, I would say that the biggest mistake investors make is probably buying these products, if they don't understand.

Peters: We have seen a little bit of a downdraft in valuation. Since the long-term Treasury rates started going up in May, we've seen utilities get a little cheaper. Staples got a little bit cheaper. The rest of the market has continued to go up. It hasn't created any screaming bargains. But again, I think if you can get a fair price on a company like Clorox; it yields a little bit over 3%, very sound long-term dividend growth potential, very safe dividend yield to begin with, thanks to their very strong brand position and cash flow. You can put that stock away. You don't ignore it; you watch it, but you don't try to beat the market with it over a year or two at a time. You think in terms of five, 10, 20 years, is this going to help me meet my objective?

In utilities, American Electric Power starts to look attractive here in the high $40s again; it yields a little bit over 4%, good solid dividend growth potential there.

Even Royal Dutch Shell, which is a very high-yielding name, yields over 5%, that has been in the market's doghouse for a long time. But they're raising their dividend, they've got the cash to continue to pay and raise that dividend, while reinvesting in order to support future growth in oil and gas production. They're doing everything I need them to do for them to meet my long-term portfolio objectives.

So, there are some names out there that, frankly, have become a little bit more attractive because Wall Street's flavor of the moment has shifted elsewhere, but that's not reason to doubt your strategy. That's a reason to actually take advantage of it.

Kinnel: I don't think anything is really a screaming buy right now. We've had a nice rally in a lot of areas, but I do think you can find some good funds that have had outflows, whereas typically you'd see a lot of small-cap funds would be closed at this point. But a lot of good ones are still open. So, from a fund perspective, I think there's a lot of good low-cost funds still available for investors looking for the long term. ...

Sequoia fund, you have to invest directly, but I think it's worth the trouble. Matthews Asian Growth & Income fund, a nice lower-risk emerging-market play. Ariel Discovery is a tiny fund run by a very good investor with a good separate account record. Or you can go with an allocation fund like FPA Crescent.