From behavioral economist Meir Statman’s great article in yesterday's wsj on the mistakes individuals make in their investing:
Investment success stories are as misleading as lottery success stories.
Have you ever seen a lottery commercial showing a man muttering "lost again" as he tears his ticket in disgust? Of course not. What you see instead are smiling winners holding giant checks.
Lottery promoters tilt the scales by making the handful of winners available to our memory while obscuring the many millions of losers. Then, once we have settled on a belief, such as "I'm going to win the lottery," we tend to look for evidence that confirms our belief rather than evidence that might refute it. So we figure our favorite lottery number is due for a win because it has not won in years. Or we try to divine—through dreams, horoscopes, fortune cookies—the next winning numbers. But we neglect to note evidence that hardly anybody ever wins the lottery, and that lottery numbers can go for decades without winning. This is the work of the "confirmation" error.
What is true for lottery tickets is true for investments as well. Investment companies tilt the scales by touting how well they have done over a pre-selected period. Then, confirmation error misleads us into focusing on investments that have done well in 2008.
Lottery players who overcome the confirmation error conclude that winning lottery numbers are random. Investors who overcome the confirmation error conclude that winning investments are almost as random. Don't chase last year's investment winners. Your ability to predict next year's investment winner is no better than your ability to predict next week's lottery winner. A diversified portfolio of many investments might make you a loser during a year or even a decade, but a concentrated portfolio of few investments might ruin you forever.
From today’s Los Angeles Times (my bolds, my comments in bold italics)
Buy-and-hold strategy losing grip on investors
Bear market losses are causing some individual investors to embrace risky moves.
By Walter Hamilton
August 25, 2009
Stung by punishing losses in the bear market, some individual investors are souring on traditional buy-and-hold investing in favor of aggressive trading aimed at scoring big gains. Trading at online brokerages has soared in recent months as investors have tried to capitalize on rising securities markets. But individual investors increasingly are embracing strategies that carry outsized risks. In some cases, for example, investors have ventured into a relatively new type of investment product designed to magnify the movement of the underlying markets. That can sometimes yield big gains if investors bet correctly but bruising losses if they don't. To critics, the push into aggressive trading is the equivalent of doubling down at a casino to recoup earlier losses. "It would be a terrible tragedy if people try to recover from the devastation of the financial crisis by creating even more devastation in their personal investment accounts by taking on risks they don't understand and can't afford," said Barbara Roper, director of investor protection for the Consumer Federation of America.
Financial experts have long preached portfolio diversification, caution and patience when it comes to long-term investing. Still, some individuals feel they have no choice but to take matters into their own hands.
Two brutal bear markets -- after the bursting of the dot-com bubble in 2000 and the housing bubble two years ago -- have decimated portfolios and left many people poorer than a decade ago.
Some have grown disillusioned with losses incurred by mutual funds and stock brokers, and figure they can't do any worse on their own by darting in and out based on market conditions....
.....Susan York was fed up with the dismal performance of her 401(k) retirement account. Then her husband saw a Sunday morning infomercial in January touting the benefits of trading options, which give an investor the right to buy or sell stocks and other securities at pre-determined prices.
The 50-year-old from Naples, Fla., had limited investment knowledge but attended several seminars before starting to trade in May. So far, York said, she's up an average of 40% a month and is trading full time.
Here's a suggestion before joining this woman in her trading career.
1 Reread the section above about lottery stories quoted at the top of this post.
2 Think about this one: Why is the originator of this 40% a month option strategy peddling it on late night tv commercials instead of managing money for billionaires?
"It's the best job I've ever had, not just for the enjoyment but from the compensation standpoint," said York, who previously sold telecom equipment. "I've replaced a significant six-figure income."...
Among individuals, activity is picking up in some risky areas.
Currency trading by so-called retail investors, for example, is expected to jump to $125 billion a day this year from $100 billion last year, according to Aite Group, a research firm. It has risen steadily from $10 billion in 2001.
Some individuals recently have jumped into one of the newest and riskiest investment products, known as leveraged exchange-traded funds. ETFs are mutual funds that trade like stocks and can be bought and sold throughout the day. A leveraged ETF is like a regular fund on steroids. It gives two to three times the return of an underlying stock index. For example, if financial shares rise 2% on a given day, a fund could jump as much as 6%. Some leveraged funds move in the opposite direction of an index. If an index rose 2%, an inverse fund could fall up to 6%.
Leveraged funds are one of the fastest-growing products on Wall Street. Total assets surged to $32 billion at the end of June from $11 billion 18 months earlier, according to State Street Global Advisors. The first leveraged fund debuted three years ago. There are now 126.
However, there is mounting concern that small investors don't understand the risks of leveraged funds.....
I have written before about the leveraged funds and how individual investors and even "professionals" don't understand how these works. Here is another example of a scarily uninformed finance professional (and a lawsuit that should be thrown at on day one)
According to a lawsuit filed this month by a Connecticut stock broker, one fund was supposed to return two times the inverse performance of an index of real-estate stocks. Thus, the ProShare Advisors' UltraShort Real Estate Fund should have risen if the index declined, according to the suit.
But even though the index sank 39% through much of last year, the fund also fell, by 48%, according to the suit.
"This should have been an extraordinary home run, and yet he lost money," said the stock broker's lawyer, Thomas Grady. "It's just preposterous."
It's not"preposterous" at all the broker should have read something about the etf before he bought it. The inverse funds are designed to give the inverse of the DAILY movement in the index. A simple knowledge of math would lead one to conclude that the long term return of this etf will not be the inverse of the long term return of the index.
The article notes this:
.Many other funds have suffered similar fates, according to researcher Morningstar Inc.
Over the last year, 55% of leveraged ETFs have gone in the opposite direction from what would have been expected, said Scott Burns, a Morningstar analyst.
The reason is that the funds are designed to track daily market moves but can fluctuate wildly over longer periods.
ProShare "touts the simplicity" of the funds when there are actually enormous risks, the suit said.
ProShare said in a statement that the allegations are "wholly without merit."
Fund companies say they warn investors about the danger in holding the funds for extended periods. "I think we've done a very good job in disclosing what these funds are, what they're not, and what they do and don't do," said Michael Sapir, chairman of ProShare Advisors....
.... experts worry that some individuals, in their haste to recover bear-market losses, are rushing in blindly.
"People shouldn't be messing around with stuff they don't understand," Burns said.
But individuals such as York believe that doing nothing is riskier than taking action themselves. She has devoted a lot of time, she said, to understanding how options trading works and believes she can prosper in good markets or bad. "I saw with my 401(k)," she said, "that buying and holding was just not working out."
So investors are reacting to the market downturn caused in large measure by overconfident finance professionals underestimating the riskiness of their leveraged trading.....doesn't sound like a strategy aimed for success.