Why the Small Investor Often Gets Hammered

The small or unsophisticated investor loses money for a number of reasons. Here are three:

(1) poor asset selection, (2) poor timing, and (3) excessive fees.

Poor asset selection refers to the tendency to invest in assets which are riskier than initially assumed. Often, novice investors chase financial instruments which have exhibited fast price appreciation in the recent past. This fast appreciation is evidence of high risk. Inevitably, over time the higher risk is realized in the form of fast price declines.

Poor timing refers to the tendency to under-invest in stocks when these are undervalued (investors buy too few cheap stocks), and to over-invest in stocks when these are overvalued (investors buy too many stocks which have already peaked and are destined to decrease in value). Poor timing often occurs because the novice investors watch as stocks appreciate in value, and eventually become worried that they will lose out while everyone else appears to be benefiting. Finally, they decide to ‘go for it’ and buy the now significantly appreciated stock. All too often, their decision to purchase is made just around the time the firm falls out of favor, leading to steep price declines and big losses.

Excessive fees are often paid by novice investors. Unknowingly, they accept investments with relatively high fees when very similar investment vehicles are available at lower cost. Higher fees dramatically undermine wealth accumulation over extended periods of time.

Often, passive investment strategies are the best frameworks for avoiding poor asset selection, poor timing, as well as excessive fees.