How not to invest: five harmful tips for traders from Barry Rietholtz

Success in the market depends not so much on knowledge as on the ability not to make mistakes, says Barry Ritholtz, founder and chief investment officer of Ritholtz Wealth Management with $6.4 billion in assets and author of How NOT to Invest. In the Motley Fool podcast, Ritholtz discusses why even experienced investors make the same mistakes and gives advice on how to stop hindering your own results.

In tennis, a professional player wins points by skill - he has a powerful serve, accuracy, and control. Amateurs play differently: they lose not because of their opponent's skill, but because of their own blunders - double serves, balls into the net, hits outside the court. "All these mistakes bring points to the opponent. If you want to win at the amateur level, you just have to make fewer mistakes," Rietholtz says.

"It's the same in the marketplace," he continues. - When people act beyond their means, they make mistakes that are costly. "I'll put together a portfolio of stocks myself," he says. "I'll guess the moment of entry." There's no point in taking public information and thinking you'll be able to trade against the pros - against those who have a pitch at 240 kilometers per hour."

The Dunning-Krueger effect works in the market: inexperienced investors overestimate their abilities, while experienced investors underestimate their abilities because they are better able to see the complexity of the market. Because of overconfidence, investors do things they are not good at and make mistakes. This was vividly demonstrated during the pandemic: the hype around "meme" stocks and the belief in easy money was quickly replaced by disillusionment. "A lot of people thought they were playing against the market," Rietholz says. - In fact, they were playing against themselves."

To be a successful investor, you need to learn to understand where your skills end and randomness begins. "This is just as important as being able to read statements or build models," Rietholz emphasizes.

Investors fail not because of poor stock selection or market fluctuations, but because they don't have a plan, Rietholz says. "'More money for more money' is basically about nothing. You have to determine: what do you need these funds for?".

If the goal is to make "more money," he says, risk quickly gets out of control - because that goal has no limits. For example, hedge funds take excessive risks for the sake of extra profits. "We see that when funds leverage ten, twenty or fifty times, just chasing even higher returns, they invariably fail," Rietholz says.

A clear goal disciplines the investor: it forces them to balance risk and horizon, plan for liquidity, and avoid impulses. "If you say, 'I'm saving for retirement, for wealth transfer by inheritance, for charity,' you can create a plan and choose assets according to it. To take only the risk that will help you comfortably go towards your goal."

At the same time, Rietholz reminds that risk is an integral part of profitability: it is impossible to completely eliminate it. Risk and reward are two sides of the same coin," he says. - If you want a high return, you have to take more risk - and that means you may not get what you want.

According to Rietholtz, younger investors underestimate their main risk advantage: time. "If you're 25, 30 or even 40 years old and the horizon is measured in decades, why sit on a pile of cash and bonds?" - he wonders. At this age, the best strategy is a combination of a broad index and a few hand-picked securities designed to look decades into the future.

The opposite mistake is taking excessive risk in adulthood. After fifty, many continue to hold overly concentrated portfolios where a significant portion of wealth is concentrated in a single security - most often employer or family business stocks. "You're already sitting on enough capital to live on - why take the risk? - Rietholz says. - It's time to cut back."

Rietholz believes that successful investing doesn't start with hunting for the "best stocks," but with proper portfolio construction. "You can't get alpha, which is the return above the market, unless you start with beta, which is the return of the market itself," he says. - You'd be surprised how many people neglect this."

Rietholz compares a portfolio to a Christmas tree: a passive portfolio is the tree itself, while active investments are the garlands and decorations. The foundation of the portfolio should work with the market - replicate its movement and returns. "If you start with beta," Rietholz says, "at least you're guaranteeing yourself the return that the market is delivering. The foundation of the portfolio should be stable, and active ideas should be dosed. "You can pick individual stocks if you want," he adds. - But do so with only a small amount of capital and with an understanding of how long to hold them and when it's really time to sell."

The main mistakes investors make are not when buying, but when selling, says Rietholz. In his book How Not to Invest, he cites a study of 780 institutional portfolios: it compares actual transactions by managers and hypothetical scenarios in which stocks were sold randomly. It turns out that in the second case, the average return of the portfolios was higher by 50-100 basis points per year.

"Purchases tend to be rational - based on an analysis of the company, its business model, dynamics, competitive advantages. Sales, on the other hand, are almost always emotional," Rietholz says. According to him, managers often sell too early to lock in profits or free up capital for new ideas, or, conversely, too late - when the original investment thesis has already stopped working.

Such decisions are particularly dangerous when you consider the structure of the stock market. Research by Professor Hendrik Bessembinder has shown that between one and two and a half percent of all public companies generate almost all long-term returns. To lose these securities is to forfeit the bulk of the returns. Therefore, Rietholz emphasizes, you should only sell when business logic has changed, not market sentiment.

In crises such discipline is not easy, because the ancient instinct "hit or run" is triggered. But even in calm periods, restraint is not easy. In the 2010s, the U.S. market was growing almost non-stop, and all you had to do to succeed was stay invested. However, that is what proved to be the most difficult for most. Investors tried to "wait out the turbulence," exiting and returning too late. "Patience is not a strategy or a skill," says Rietholz. - It's a form of endurance, without which none of the others work."

This article was AI-translated and verified by a human editor