Investing Traps

How to survive in the investment jungle by avoiding common pitfalls

Small profits, raise stake - big losses later

Small early gains can be wiped out by bigger losses later by increasing stakes as prices rise

Early Breaks for Suckers

Paradox: When faced with an unknown situation, a reasonable man would surely first watch developments to learn, then try putting a toe in the water before making the plunge. So why does taking a bath in the market often follow this?

Fallacy: This is to assume that one is alone, when in fact a majority of market participants are in fact going through the same learning experience at the same time, thus driving prices higher as they engage in the same investment strategy at the same time.

Example: The thick white line represents the performance of any stock market index while the yellow line in this chart shows the performance of a portfolio, using this strategy. Typically investors miss the first cycle because they are not interested, miss the second while they are learning, make only modest profits in the third when they make tentative initial investments, and then, finally fully committed, make initial large gains. When the pattern breaks down the investor is left with loss-making positions on the way down that are much larger than profitable ones held on the way up. The effect is that, even though the market remains above its starting level, the investor has, on balance, lost money.

Solution: Rather than observing developments as they occur along with everyone else, a study of stock market history can often unearth similar developments at other times and places. Investors RouteMap is an cost-effective historical resource, focussed on global asset allocation, that has quantified lessons over half a century for up to 50 markets and regions.

Most professionals sit on the fence to protect their jobs - as in the Millennium bubble

  Typical Asset Allocation  
  UK Institutional Investors  
  Average Scared Bold  
  Domestic 55 50 60  
  Europe 5 3 12  
  USA 8 2 9  
  Japan 3 1 4  
  Asia 1 1 3  
  Domestic 9 18 5  
  Foreign 8 15 1  
  Cash 8 10 2  
  Property 3 0 5  
  Total 100 100 100  
  Equities 72 57 88  

Leave it to experts

Paradox: If they are so expert, how come their results are so average? Several studies of fund manager's performance have shown that, on average, their results are much in line with the indexes or indeed worse.

Fallacy: This lies in believing that because you are paying for active fund management, that is what you are getting. Closet index-linking is widespread in the industry as fund managers pursue the same marketing policy of marginal differentiation as car or canned goods producers.

Example: The table alongside shows a sample portfolio distribution of assets among the principal classes for managed pension funds, (The chart alongside is partially drawn from European Pension Fund Managers Guide 2000 by William Mercer). This is a simplification as many managers also offer some specialist funds. Here one can see that even extreme positions of aggression or conservatism nevertheless include some holdings in all but the smallest categories and that the range of variation on the big decision - Equities versus Bonds & Cash - is limited.

Solution: Invest in exchange traded funds and select only those where you expect the market to out-perform. Arm yourself with an independent source of analysis and advice on which markets represent good value and show positive momentum. That will provide risk diversification without closet index-linking. Investors RouteMap is designed to help in that it advises both on individual countries and regional aggregates chosen to reflect the most popular institutional mandates. Its "active quant" international investment strategy is designed to beat such "passive quant" managers.

Mathematically, this strategy is bound to lose

Taking profits is a loser's investing strategy because it insures against big winners, but not against big losers

Take profits and run losses

Paradox: Investment textbooks generally recommend running one's profits and cutting one's losses, so why do investors regularly do the opposite? Theoretically the whole point about limited companies is that one can only lose 100% of invested capital but can make several times that in profits.

Fallacy: This lies in the mistaken belief that the only real losses are the ones that are taken, and that taking losses is therefore an admission of defeat, which is psychologically hard to accept.

Example: The thick white line represents the performance of any stock market index while the yellow line in this chart shows the performance of a portfolio, by taking successive small trading profits on the way up. However on the way down the failure to cut the loss results in a single losing position wiping out all the hard-won gains of several successful trades, despite the fact that the index ends up higher than it started.

Solution: Almost any disciplined international investment strategy will improve on this because it will impose the same rule on winners and losers. Investors RouteMap provides a variety of such disciplined strategies applied consistently across all markets and comprehensively back-tested, where appropriate.

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Dealing expenses > cost of advice 

  Brokerage Costs  
  £5000 Investment  
    Bundled Unbundled  
  First Trade 80 50  
  Take Profits 90 -  
  Second Trade 90 -  
  Take Profits 100 -  
  Third Trade 100 -  
  Take Loss 80 50  
  Trading Costs 540 100  
  Shares RouteMap - 300  
  Total Costs 540 400  


Free lunches

Paradox: If everyone knows that there is no such thing as a free lunch, why do people queue up? Someone has to pay for it. That someone can only be the supplier or the customer and probably it is the supplier directly, but the customer indirectly.

Fallacy: The customer may well suspect that there is a hidden cost to him, but because it is hidden his fallacy lies in assuming that the cost is small, when in fact it is often substantial. The broker offering free research is covering the cost through higher commissions, which is fair enough. However this means brokers only gets paid when the customer deals, so they have every incentive to generate new recommendations. This inevitably means taking frequent profits in contravention of the principle of running profits and cutting losses.

Example: This contrasts the costs of dealing actively through a full service broker and a discount broker with an independent investment adviser. The former takes 10% profits on two trades and then runs the loss on a third for a round-trip that makes no gross profit, but chalks up £540 in commissions. The latter makes an initial investment, which appreciates comparably, before also falling back to its starting value. Even after spending £300 on an independent investment adviser, this equally unsuccessful policy, only runs up expenses of £400. 

If it is cost-effective for even such a small investor, independent research must make even more sense for anyone with a substantial portfolio.

Solution: Unbundle dealing and advisory services. The discount broker is not paid to churn accounts and an independent investment adviser can happily issue hold recommendations, allowing your profits to run as they should, because he is not paid by activity. Indeed strategies used in Investors RouteMap have built-in turnover suppressants designed to keep the number of Buy & Sell Signals for each investment down to around two a year.

A track record is as good as its starting point

Performance measurement is a question of when you start

Performing Statistics

Paradox: If prices are a function of supply versus demand, it is unsurprising that the investments most in demand are those that have the highest prices, i.e. they performed best in recent years. Thus it is entirely appropriate that fund managers should meet this demand by launching new funds at a time of high prices and equally reasonable that they advertise with pride their track record in the appropriate field. Why then is future performance so often disappointing?

Fallacy: This is that over the long term share prices don't rise in an exponential manner, but fluctuate cyclically around a rising trend that is determined by economic growth, inflation and manias.

Example: Here a buyer at point B will see a poor track record expressed in the red arrow, but can expect good prospects shown in the green arrow. The buyer at point C will see a good track record shown in the green arrow, but can expect poor prospects, as displayed in the dotted red arrow.

Solution: This lies in gaining the courage to be a contrarian, and that is the product of motivation and knowledge. Assuming you have the motivation, Investors RouteMap is designed to provide the necessary knowledge by picking out those markets where valuation is cheap and momentum is turning up. In this way judicious global asset allocation can help you improve performance, while also lowering risk.

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Investing Traps for Suckers is part of the free international investment seminar. Just follow the classroom images alongside, either now or at the end of your tour. At the end of each class, there is a sign to the beginning of the Next Class.