Investment Mistakes Even Smart Investors Make and How to Avoid Them (Book Review)

Investment Mistakes Even Smart Investors Make and How to Avoid Them (Book Review)

OUR RATING
4/5

Einstein once said that common sense is the collection of prejudices acquired by the age of eighteen. Similarly, much of what is conventional wisdom on investing is wrong.

Larry Swedroe is an eminent proponent of evidence-based investing and a prolific author. Apart from co-authoring numerous books, he is also an avid blogger, and he participates actively in online evidence-based investing communities. Larry is currently the Head of Financial and Economic Research at Buckingham Strategic Wealth.

Many of Larry’s books cover advanced investment topics in an academic way that can come across as rather dry. However, in “Mistakes Even Smart Investors Make and How to Avoid Them” Larry has teamed up with the economics journalist RC Balaban to re-visit a variety of basic investment concepts in a more approachable way.

Most people can get by just fine without knowing anything about, say, rocket science. It is substantially more difficult to get through life without being knowledgeable about finances.

Today’s let’s have a look at a book that helps create investors that are more likely to achieve their goals.

KEY TAKEAWAYS

  • Larry and RC have collected 77 investing mistakes that investors commonly fall prey to. Each mistake and the evidence behind it is briefly presented in its own chapter, sometimes using personal stories, along with tips on how to avoid it.
  • Even though chapters are relatively short, they are informationally very dense. An effective way for readers to digest the material is to focus on one mistake per day to let the material sink in.
  • The mistakes can also be used as prompts for interesting finance-related discussions amongst families, friends, or investing groups.
  • There are four parts in this book dealing with mistakes that fall into the same broad theme, which we briefly summarize below.
  • This book does not put a particular focus on personal finance, but touches upon how to think about the opportunity cost of spending, how to think about withdrawal rates in retirement, and the importance of saving money early to let compounding work its magic.
Here is the full analysis

buying a hot company stock is Like betting on a winning NFL team

Part 1: Behavioural Biases

"Very few investors manage to beat the market. But in an astonishing triumph of hope over experience, millions of investors keep trying." - Jonathan Clemens

Behavioural economics is a research field that has produced many Nobel prize winners, like Daniel Kahneman, Robert Shiller, and Richard Thaler, who showed that human psychology profoundly affects financial decisions in a multitude of ways. Knowing about these behavioural shortcomings is useful to try to avoid them, but it cannot eliminate them completely.

We humans tend to see patterns in randomness. 

This can lead us to attribute the superior performance of a fund or of our own stock picks to skill, when it has been shown that it is mostly the outcome of chance. An apparent “hot streak” of a few recent accidental successes (we conveniently forget our older failures) combined with a dose of hindsight bias (which makes all outcomes appear obvious after the fact) can quickly make us overconfident in our abilities. 

This can have disastrous consequences, like taking excessive and unrewarded risks by investing in individual companies, industries, or countries. 

To make matters worse, when these mistakes are pointed out by a more knowledgeable friend or advisor, our ego gets in the way and does not allow us to admit them.

You might even think that having higher-than-average IQ is helpful. Well, think again: a study described by the authors showed that Mensa members actually make terrible investors.

If the evidence clearly shows that even the brightest people make big behavioural mistakes, then, surely, we will too. 

So, what should we do? 

The authors suggest keeping a strict diary of our investment decisions and outcomes as an exercise in humility. When we are inevitably humbled by what we discover, we can admit that the future is both unknown and unknowable and that the only sensible way to invest is through a globally diversified portfolio of passive index funds that reflects each investor’s unique ability, willingness, and need to take risk.

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As of 29/03/2024, Interactive Brokers offers rates up to 4.738% (GBP), 3.445% (EUR) and 4.83% (USD) on cash. 

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As of 29/03/2024, Interactive Brokers offers rates up to 4.738% (GBP), 3.445% (EUR) and 4.83% (USD) on cash. 

Part 2: Knowledge is Power

"If investors ignored the noise, not only would they earn better returns, but they would also lead more productive lives"

You're hearing noise(s)

TV, newspapers, YouTube channels, and online discussions produce a massive amount of stock-market-related news and information every day.

 Studies show that new information is incorporated so quickly into stock prices that it cannot be exploited by individual investors. In other words, stock markets are ruthlessly efficient

Even if market inefficiencies could be systematically exploited, doing so would make them disappear while also incurring high trading costs and taxes to the investor. As such, this type of daily information is not knowledge, but noise.

So What Is Really Stock Market Knowledge?

What is Stock Market knowledge according to the authors?

  • Knowing that a great company is not always a great investment – A company or sector that may seem to have a great future does not necessarily make a great investment.
  • Knowing that only unexpected information makes outperformers –  Absolute Earnings or sector growth do not matter as much as growth compared to the expectations of the market. A stock or sector that is expensive, as measured by the price-to-earnings ratio, has low expected returns, unless it positively surprises the market.
  • Knowing that costs are key – Fund costs matter and there is more to costs than the expense ratio. Funds also have to pay taxes on dividends and capital gains, they have to pay trading fees, and their returns can be lowered by holding a lot of cash. A fund strategy might look very appealing historically, but these are often reported without considering costs. In general, the more a fund trades, the higher its overall costs.
How will this knowledge help us uncover Portfolio Managers’ Tricks?
 
  • Benchmark and Cost Tricks – fund providers can play many tricks, especially with actively managed funds. There may be additional fees that are not emphasized sufficiently. Fund providers may be using inappropriate benchmarks for their funds (e.g., a fund investing in small companies is compared against the S&P 500). 
  • Performance Tricks – The name of the fund may not accurately reflect what the fund is actually investing in. They may be exploiting survivorship bias and incubator funds to show exceptional past performance, which is not likely to continue. 

The warning “past performance is not a predictor of future results” has almost become an Internet meme. But it should be taken very seriously.

In short, knowledge is information that is timeless and valuable to the investor. Knowledge is information that has a solid theoretical foundation and is backed up by empirical evidence. 

All other information is noise as far as investing is concerned and can be safely ignored.

Rebalancing, Cash Flows and How To Deal with Inflation

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Part 3: Investment Strategy

“Those who fail to plan, plan to fail.”

Why Bear Markets are Great

Investment returns are a compensation for the risk an investor is taking.

In that sense, a bear market is a good thing: it shows that there is still risk, so we can expect a reward. 

Unfortunately, investors often do not understand the nature of risk:

  • You should benefit from ‘Good’ risk – The stock market has been shown to reward “good” systematic risk, which is the overall risk of stock investing that cannot be diversified away. Investing in individual stocks carries additional “bad” unrewarded risk and should be avoided. Even too much “good” risk can be a bad thing when it is not necessary to achieve an investor’s objectives.
  • Risk is not only volatility –  While volatility is certainly a risk, risk can mean different things to different people: some investors might care more about the risk of their investments being expropriated by an unfriendly government while others might mainly care about how their investments are doing compared to a psychological benchmark, like the S&P 500.
  • Stocks don’t get less risky in the long run – It is a common misconception. This is simply not true, as stocks can underperform less risky investments for very long periods of time. Diversifying a portfolio across sources of risk other than systematic market risk, such as term risk from bonds or value risk from stocks with low price-to-earnings ratios, can improve these bad outcomes drastically. It also turns out that diversification is even more important over the short term.

One solution to this problem is an IPS.

An investment policy statement (IPS) is a living document that is updated regularly or when an investor’s life situation changes significantly.  

It includes at the very least the investor’s objectives, asset allocation, rebalancing strategy, and insurance requirements. When things inevitably go south, a detailed IPS will function as a lifeboat that can save your investment life.

Part 4: Portfolio

“Some products are meant to be sold, not bought.”

What Not To buy

Nowadays, investors can choose among thousands of publicly traded stocks and bonds and an even larger number of funds, leading to a situation that is succinctly described by the German phrase “die Qual der Wahl” (“the agony of choice”). 

Fortunately, avoiding some common mistakes and misconceptions can help an investor narrow down the available options. 

Many products that fund providers love to sell, but that should not be bought by investors:

  • Active funds promise to beat the market.
  • Initial public offerings (IPOs) are shiny and exciting.
  • Focused funds concentrate only on a few best stock picks of a fund manager (or sometimes multiple managers) hoping to achieve higher returns.
  • Complex high-yield investment products might have some aspects that appear mesmerizing to the investor, but likely have hidden traps.

All the above products have been shown to perform poorly on average and can safely be ignored as investment options.

Even passive index funds are not created equal

But even passive index funds are not all created equal, although they are much more transparent. The construction of the index that these funds follow is crucial for costs and exposure to rewarded risk factors. 

Some passive funds may do a much better job than others. 

It includes managing taxes and sharing additional income from securities lending with investors. The general approach of all investors should be: don’t trust, verify.

Diversification should not only be measured in terms of the number of holdings, but taking into account:

  • Overlap – diversifying across funds without looking at their contents does not make sense as they may have significant overlap.
  • Similar Risks – Even a portfolio with dozens of stocks may be exposed to similar industry-specific or geographical risks

The most effective way to diversify a portfolio is to ensure that it is exposed to different risk factors. 

For example, small companies face different risks than large companies, value companies face different risks than growth companies, and high-quality government bonds can add term risk to the mix.

The final mistake even smart investors make is repeating previous mistakes! After reading this book, the authors say that you will have no excuse for making the same mistakes over and over. 

This might seem like a rational claim, but we nevertheless think it is much easier said than done.

Advertisement

As of 29/03/2024, Interactive Brokers offers rates up to 4.738% (GBP), 3.445% (EUR) and 4.83% (USD) on cash. 

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As of 29/03/2024, Interactive Brokers offers rates up to 4.738% (GBP), 3.445% (EUR) and 4.83% (USD) on cash. 

SHOULD YOU BUY THIS BOOK?

How we rated the book

Our overall rating comprises five key considerations, including suitability for beginners and European and UK readers.

OUR OVERALL RATING
4/5
1. Beginner-Friendly
4/5
2. Investing Concepts
5/5
3. Investing How-to (Europe)
3/5
4. Financial Freedom Principles
2/5
5. Personal Finance Know-how
2/5
OUR OVERALL RATING
3.8/5
1. Beginner-Friendly
5/5
2. Investing Concepts
5/5
3.Investing How-to (Europe)
3/5
4. Financial Freedom Principles
2/5
5. Personal Finance Know-how
2/5
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Rating Justification

This book is not an investing how-to for complete beginners and, while the authors do their best to define the terms they use and to use casual language, academic jargon and dry writing style still occasionally slip through. 

Nevertheless, it can teach both beginner and intermediate investors valuable lessons and it can be re-read multiple times.

The concepts treated by the authors are thoroughly evidence-based and timeless. A small hiccup in our view is that a few of the cited references consider somewhat short timespans and are thus less convincing.

There are very few sections that are targeted only at US-based investors, and these mostly have to do with taxation. For example, the concluding chapter contains twelve concrete steps for disciplined investing, where only one step is specific to the US taxation system. 

Also, the authors generally advocate for globally diversified portfolios, which is the right approach for all investors, including Europeans, according to the evidence.

This book does not put a particular focus on personal finance and financial independence. Nevertheless, the authors touch upon topics that are very useful from this perspective. For example, they explain how to think about the opportunity cost of spending, how to think about withdrawal rates in retirement, and the importance of saving money early to let compounding work its magic.

Thank you for reading.
Good Luck and Keep’em* Rolling!

(* Wheels & Dividends)

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