Monday, July 2, 2012

Common Investor Errors...

Early last week, Barry Ritholtz outlined what he believed were the top ten most common investor errors:

Here is my short list:

1. High Fees Are A Drag on Returns
2. Mutual Fund Are Inferior to ETFs
3. Reaching for Yield is Extremely Dangerous
4. Asset Allocation Decisions matter more than stock selection
5. Passive is usually better than Active Management
6. You must understand “The Long Cycle”
7. Behavioral Issues Are Costly
8. Cognitive Errors as well
9. Understand your own risk tolerance
10. Pay Guys Like Me For the Right Reason

While I think this is an interesting / solid list, I don't necessarily agree with a number of them. In his post I responded with the following:
Can we disagree on some of these?

2. Mutual Fund Are Inferior to ETFs: Too broad a statement. Some mutual funds are great (inexpensive, track indices almost exactly, prevent owners from day trading [see your #7] behavorial issues being costly), while many ETFs are very poor (broad tracking error, expensive, leveraged inverse ETFs)

3. Reaching for Yield is Extremely Dangerous: Everything is based on appropriate compensation for the risk an investor takes… 5 years ago an investor sitting in cash received [a 4-5%] risk-free return. 0% [yielding] cash is now return-free risk. An investor “reaching for yield” now may actually now be a risk reduction exercise.

4. Asset Allocation Decisions matter more than stock selection: agree, but by definition asset allocation decisions are “active” decisions, hence….

5. Passive is usually better than Active Management: seems in conflict with #4
Diving right into my point #2 (because ETFs seem to be uniformly praised these days) is that mutual funds are not all inferior to ETFs (stating ETFs are superior is too broad of a statement). This is especially true for sectors / asset classes where the underlying securities are less liquid and the ETF itself trades with minimal volume (volume isn't nearly as important if the underlying securities are liquid... a point for another day). In these instances, it is more likely that the price of the ETF can move significantly from the ETF's net asset value "NAV" (the actual value of its holdings) and the bid/ask spreads widen, both of which can be negative to an investor.

One example can be seen year-to-date with Muni ETF MUB performance relative to that of a muni mutual fund. I am not vouching for the Fidelity fund below (it was the first to come up when I looked for a national muni fund with roughly 7 years of duration).

In addition to the underperformance of MUB, the volatility is 3x higher at 6.8% vs 2.2% due to the widely fluctuating ETF price vs the underlying NAV which hit a 4% premium in February (i.e. someone buying that day paid 4% more than the securities were worth).

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