Newbie Investors have been cropping up everywhere since the advent of the Covid-19 virus. Some people refer to these investors as the Robinhood or Reddit crowd. This new group of market participants along with more established Do-It-Yourself (DIY) investors do not rely on investment professionals to manage their money.
Newbie’s, for the most part, believe that current investment methods are obsolete and behind the times. They see little need for using more traditional ways of managing money. They prefer to pull the trigger themselves and in fact derive great satisfaction from beating the establishment. They are the new kids on the block.
DIY investors, on the other hand, have been around for a while. There was a big jump in DIY investors around the time of the Great Financial Crisis of 2008. Many DIY investors used to have professional advisors manage their investments but became disillusioned with the results and concluded that they could do as good or better job than their advisors.
Many Newbie and DIY investors have taken the time to educate themselves about investing. Not everybody requires somebody to hold their hand to achieve superior results, but many do. Many Newbie and DIY investors have never experienced a gut churning market meltdown such as 1987, 2000-2002 and 2008. They have experienced mild corrections that quickly reverted back to an uptrend. They have lived their investment lives in a low volatility environment with declining interest rates and hardly perceptible inflation.
How will inexperienced investors likely react?
Remain Cool and Collected ?
Doubtful!
After all investors are human and when humans are involved emotions take over especially during periods of market stress. Your head may be saying stay the course and don't panic but your stomach is churning and your palms are sweaty.
Professionals are not immune from experiencing these emotions. Nobody likes seeing red on their screens!
When markets tank the primary investor emotion is raw, gut-wrenching fear
Fear in turn is followed by regret and self-doubt
These are all human emotions felt by amateur and professional investors alike. The difference is that professionals usually keep a little space between the time their palms become clammy and the actions they take. Enough time to reflect on past periods of stress and the lessons learned. Enough time to rationally respond (or not) to the fear of the masses.
Only experience and applied know-how stand between wanting to chuck it all to relieve the fear and a clear mind focused on both the opportunities and risks of the situation.
Fear and its close cousin, regret, create mistakes if you let these emotions drive your investment decisions.
Inexperienced investors tend to do well when capital markets exhibit low volatility and the trend in price is well established. Everybody loves up-trending markets that don’t fluctuate much. But as Humphrey Neill, a famous contrarian investor, used to say “Don’t confuse brains with a bull market”.
The analogy I like to use is that of a pilot. When everything is calm even a novice will look good. But when the friendly skies become turbulent, a novice pilot will likely tense up and the odds of making a mistake increase significantly.
Inexperienced investors face the same situation. During periods of calm, portfolio decisions will come easily. The cost of a poor decision is not likely to have major consequences in a benign environment.
But when the capital markets get dicey, the implications of one’s actions increase dramatically. A poor decision could decimate the value of your portfolio and seriously harm your overall financial health.
Inexpereinced investors are ill-equipped to deal with extreme capital market stress
Stock market corrections are not fun for anybody, but experienced investment managers have the real benefit of having seen a movie of the same genre before. Corrections are often a mere blip on a stock chart but crashes are something else.
As a professional investor, I have lived through the 1987, 2000-2002, and 2008 stock market crashes. None of these were fun but I learned valuable lessons in each of these crisis. I mainly learned not to panic. I also learned that at times one must course correct if the fundamentals warrant it. Standing pat might sound noble but could also seriously harm your pocket book!
Many DIY investors and certainly the Robinhood/Reddit crowd have not seen a real crisis in their investment lifetimes. The Covid-19 market event was a mere correction, not a crash as the market had pretty much recovered by year-end 2020. While everybody can read about stock market crashes unless you live through such a period it is hard to truly understand their impact both on your pocketbook but more importantly on your psyche.
A crisis such as 2008 is extremely disorienting even for professional investors, but the advantage that experience and knowledge of capital market behavior affords is a game plan honed by the school of hard knocks.
Without the benefit of having lived through previous periods of real capital market stress and the knowledge of how markets typically behave, inexperienced investors are at a significant disadvantage.
The potential for mistakes goes up exponentially in a crisis especially if you're an inexperienced investor
Mistake #1
Selling everything in a panic
No questions asked, just get rid of everything that is taking a hit before it gets even worse.
Taking action by selling everything may give you a sense of relief. But making decisions in a highly charged emotional state is asking for trouble.
If the decision to sell is based on solid research and is well thought out, fine. But if it is based on impulse and an immediate need to get rid of the stress then it is most likely that the portfolio was not appropriate for the individual in the first place. Investing comes with volatility, there is no way around this!
Oftentimes when an investor sells in a panic the most troubling decision is when to buy in again. Even worse if the decision to sell turns out to be wrong, the investor will endlessly question themselves and lose confidence in their ability to navigate on their own.
Inexperienced investors tend to focus on the initial portfolio composition or asset allocation but often fail to plan ahead should market conditions change. And if there is one thing that holds true is that change is inevitable and an ongoing part of financial markets. Planning ahead for changing market conditions is an integral component of a well-designed investment plan.
Fortunately, most inexperienced investors know that impulsively selling everything in a panic is not a good wealth creation strategy. But don’t kid yourself – in a market meltdown you will want to sell everything and more! And that is when regret kicks in.
You will have to control your emotions and have the stomach to weather the inevitable periods of market turbulence if you hope to become a successful long-term investor.
Mistake #2
Freezing up
Most market corrections are short-lived and while painful in the short-term they barely register on the long-term map. For example, in 2020 during the onset of Covid-19 we experienced a deep correction in the spring but by fall the market had recovered most of its losses.
No harm, no foul! Doing nothing or standing pat works just fine when markets recover quickly.
The bigger problem for investors is when corrections take on a bigger life and become outright market crashes. For example the S&P 500 was down three straight years from 2000 to 2002. What do you do when the roof seems to be caving in?
Many inexperienced investors close their eyes and pretend that this is not happening to them. They freeze up and choose to ignore reality.
This is not an abnormal reaction at all for us humans, but we also know that small problems many times lead to big problems if we do not address the underlying issue. I know of many people that on paper were multimillionaires during the Tech boom of the late 90’s only to wake up three years later to almost nothing.
Wishing the problem away does not work. Behavioral finance researcher have shown that investors tend to hang on to their losing investments way too long. The flipside is that research has also shown investors to sell their winners way too soon. This effect is known as the disposition effect.
The price of financial assets such as stocks is a function of fundamentals (growth and profitability), the fair price of those fundamentals (investment multiples) and the sentiment of buyers and sellers.
During a period of crisis, the tendency by inexperienced investors is to focus almost exclusively on sentiment. When sellers want out now and buyers are scarce the price will automatically come down. Not a fun place to be for any of us.
During a crisis all you see are falling prices and investors ready to jump off the cliff in despair. Before you join them ask yourself if there is any real economic information in how investors are feeling. Is the fear justified by a sharp drop in fundamental values?
Experienced investors while not immune to the same feelings of fear will look at the underlying fundamentals and the value of those fundamentals. Experienced investors know that investor sentiment is fickle and lacks predictive ability.
- Has something changed recently to warrant this drop in market values?
- Are growth rates and profitability permanently impaired, or is the market over-reacting?
- Are investors reacting to the perception of market over-valuation?
These are all questions that require some real expertise and most importantly an understanding of context.
There is no cookie cutter way to analyzing market action. The only thing you got in a crisis is experience in similar conditions coupled with knowledge of historical market behavior. That combo is most valuable in a crash scenario.
Inexperienced investors often lack an understanding of context and an assessment of prospective fundamentals in the face of wildly fluctuating capital market conditions. They thouhgt that investing was easy but all they have seen is a rising tide.
The tendency by many investors is to stand pat, but what if changing market fundamentals require a change in portfolio positioning?
Mistake #3
Not adjusting to changing risk levels
A frequent mistake made by inexperienced investors is to focus almost exclusively on returns and ignore the risk and correlation structure of their portfolios.
In fact, it’s been my experience in evaluating thousands of new client portfolios that inexperienced investors are often extremely concentrated in one or two themes without realizing the risk of such an approach. These themes carry their own risk profile which at best is poorly understood and in most cases not even considered.
I will go out on a limb here by saying that very few amateur investors understand the risk profile of their investments. They may understand why they hold what they own but can’t quantify the risk of their overall investment.
Do many newbie investor even understand the concept of investment risk?
Ignoring changing asset volatility and correlation is a serious mistake made by many non-professional investors.
By ignoring the volatility structure of portfolios investors are foregoing some of the lowest hanging fruit available. As Nobel Prize Winner Harry Markowitz once said “diversification is the only free lunch provided by capital markets”.
As capital markets change over time so will the risk characteristics of a portfolio even if the portfolio is rebalanced to static weights.
Stock volatility, in particular, can move quite a bit around. Bond volatility while still variable shows much lower variability. And, correlations between stocks and bonds can move between positive and negative values implying large changes in diversification potential for a portfolio.
The image above shows a snapshot of the 20 day rolling volatility of the S&P 500 and the Bloomberg Aggregate Bond Index. The volatility of stocks has fluctuated between 7 and 21% in the last year. That’s huge.
Similarly the volatility of bonds has also shown a wide range from 3 to 6% on an annualized basis.
Capital markets are not static. Even if you rebalance your portfolio as advocated by many advisors your portfolio volatility will fluctuate massively during periods of market stress.
Say, an investor has a portfolio composed of 60% US stocks and 40% US Bonds. The investor diligently rebalances this portfolio so that the weights stay in sync.
What would this 60/40 portfolio look like in terms of volatility?
Using the last year as a guide the average volatility of this 60/40 portfolio would be about 8%. Assuming that the average volatility would not change much would, however, be a mistake. The range of volatility goes from 4% to 13%.
Even the old standby 60/40 portfolio exhibits wildly fluctuating levels of portfolio risk. A 4% volatility level implies a much lower level of potential downside risk compared to a portfolio with a volatility of 13%. Experienced investment professionals inherently understand this and often seek to target a narrower pre-defined range of portfolio volatility.
I have never heard of Newbie or DIY investors that construct portfolios targeting an explicit range of risk. They focus almost exclusively on returns. The often hidden assumption is that over the long-term asset returns, volatilities and correlations will gravitate toward their “normal” levels. These assumptions are not supported by the empirical evidence.
For inexperienced investors, changing levels of volatility and correlations can cause significant changes to the risk/returns characteristics of their portfolios. For example, volatility tends to spike up during periods of capital market stress and remain low when markets are trending up.
Also, correlations among investments within the same asset class (broadly speaking equities, bonds and alternatives) tend to also jump up during periods of crisis leading many to question the benefits of asset diversification.
What investors should be questioning instead is why they did not re-adjust their portfolios to reflect the changing conditions?
Conclusions
