Avoiding 5 Big Investment Traps

My mission in the market is quite simple: brain-dead investing. Even better: emotionless investing. I work hard to study systems and methodologies that have worked over time. Then I load a computer (or just a pad of paper) to put these systems on auto-pilot, and I make rules for investing so I can shut off my brain, shut off my emotions, and make money. Sounds good, doesn't it?

It's worth a shot. In a world where 80% of mutual funds lag the performance of the major market indices, the bar for success is not high. You have a chance to win just by avoiding the most glaring and obvious market traps that get you into trouble.

Most people over-think or try to game the market. Or they think of the market as "one big thing" that moves up and down. But the market is made up of thousands of interconnected stocks and other investment vehicles, all moving in different directions at different points in time.

But if there are so many traps in the market, what should you do? My advice: Ignore them, relax, and settle on a decent value-based investment strategy. Let's look at some of the biggest "traps" of average investors.

1. Fees: As I said, 80% of mutual funds lag the major market indices. So why would you pay them a fee to underperform? The average return on the S&P 500 Index during the past few years has been about 2% annually. Throw in a 1% fee, and you have lost half your gains. Amazingly, there are plenty of funds with sky-high expenses. Statistically, if you pay a higher price you are not likely to make it up.
   
   If you want to be a passive mutual-fund investor, it makes a lot more sense to put your money in a low-cost general market index fund or ETF like the Vanguard Total Market Index (NYSE: VTI). At least you have a good chance of being in the 20% that beat the other 80% -- and you avoid the higher costs.



2. Over-trading: Not only does trading incur extra fees, but it makes you susceptible to bad decisions. People tend to make the worst decisions when they are emotional. Market extremes bring out emotions -- and make people trade. Try to keep your emotions in check, and reduce your trading. See if you feel better.



3. Trading to "get rich": It's an age-old scenario. The neighbor, or your broker, has a stock tip on a company that makes no money but could increase tenfold. Its profits are precisely zero. But because the stock is $1 it could go to $2 and you would promptly double your money. But what is the statistical edge here? It's one stock, and the company makes no money. The risks are extremely high. Why bother, when you can buy a profitable enterprise trading at a discount to cashflow?



4. Not having a long-term strategy: When a financial crisis occurs, which is bound to happen (often), most people don't know how to react because they have not prepared for what they would do. We all know there will be another market panic, because there is always another market panic. Are you prepared for that scenario? I am a big fan of saving money to always have dry powder, and putting money to work slowly over time. This approach can temper your emotions and put you into a position of strength to take advantage of extreme moves.
   
   For example, what if you just saved $4,000 a year, and said, "I'm going to invest this money whenever the VIX is over 30." The VIX is an index that measures volatility. Periods of elevated volatility over time have proven to be decent times to buy. The chart below shows a reverse correlation between the VIX and the markets. This may not work perfectly as an "all-in" trading strategy, but if you are putting incremental cash to work over time it can be a good guide for when to try buying a few extra stocks. As Warren Buffett says, "Be greedy when others are fearful."
   
   
   VIX vs. the S&P

   

5. Being too emotional: This is related to the last trap -- it's the converse. Selling into extreme fear can be very dangerous. It's easy to fall into this trap. Sometimes the worst decisions are made at the most emotional times.
   
   Another way to think of the VIX is as the "fear gauge." Take another look at the chart above. When the VIX is generally above 20, fear is elevated, and when it hits 50 you are in panic mode. Think of October 2008 or March 2009. Everybody thought the world was ending. Great time to invest for the long term -- some of the best stocks were available at their cheapest levels in decades. As you can see above, elevated volatility (more emotional times) has been correlated with great opportunities over the last five years. Definitely not the most opportune time to sell, but possibly a great time to buy.

I advocate a "system" or "framework" for investment, because it enables you to make disciplined decisions rather than rash ones. It makes the decisions for you, rather than you being forced by emotions. Rash decisions can cost you.

Be rational. Be diversified. Make decisions slowly and methodically. Don't react like the crowd.

If you are making emotionally driven decisions in specific points in time, your chances of falling behind the market are pretty high. And if you do follow some kind of system -- even something very basic like dollar-cost averaging into conservative stock indices -- chances are you will at least perform with the crowd, and possibly better, and you won't make decisions that kill yourself.

Tomorrow I will detail specific "brain-dead" investment strategies or investment systems that have worked over time.