There are basic pitfalls that investors always face, no matter how long they've been in the game.peshkov/Getty Images/iStockphoto
Ryan Modesto, CFA, is Managing Partner at 5i Research, a conflict-free investment research provider for retail investors offering research reports, model portfolios and investor Q&A. 5i Research provides content under an agreement with The Globe and Mail, which receives royalty compensation. Try it.
Back in November, we launched an initiative to promote financial literacy by encouraging high school students across Canada to take part in an investment simulation competition.
The top participants were eligible for a total of $10,000 worth of scholarship awards to put toward their education.
Along the way, we learned about many pitfalls that people come across when approaching the topic of financial literacy. After getting some feedback from some participants, we realized the most important lesson in terms of promoting financial literacy was that a carrot would work much better than a stick. Since "you don't know what you don't know," younger generations are not going to realize how rewarding investing can be, personally and financially, until they're given a chance to test things out. But for better or worse, most are not going to dip their toe into researching stocks/ETFs and investing out of the blue and this is where providing the carrot (in our case monetary awards) comes in handy.
The reward does not have to be monetary, but if others are serious about improving financial literacy, there needs to be some sort of carrot coupled with a more formal education that encourages younger generations to test the waters in what can be a deep and daunting ocean.
The other lesson we found interesting is that whether you are a beginner in a high-school stock simulation or a seasoned veteran, there are basic, maybe primal, lessons and pitfalls that investors always face and probably always will in some form. Here are some of those common themes we saw in this stock simulation and the same themes we see in all investors.
When to sell
This was the No. 1 difficulty that participants faced. And it should be no surprise that this is probably the No. 1 issue that all investors face, beginner to advanced. There is no right answer on when to sell. The important thing to do is to set upon a method or process that works for you and follow it. At 5i Research, our philosophy is to sell when something fundamental has changed and not just because a stock is down.
Holding on to losers and selling too early
This is a bit of a derivative of "when to sell" but should come second on the list of issues and pitfalls that all investors come across. Selling winners too early to lock in gains and holding on to losers (if you liked it at $10, you'll love it at $5) is likely the most costly mistake that investors make. In most cases, a stock is going up because good things are happening and a stock is going down because bad things are happening. Selling the winners means you leave yourself with a portfolio full of losers that are facing problems.
Misjudging risk tolerance
Due to the nature of a stock simulation, the timeframe is typically shorter than it should be. The natural conclusion many make is that leveraged ETFs are the answer to short-term success. This is also the largest criticism of these types of simulations, in that it promotes short-term thinking. While it's a fair criticism, we challenge those critics to come up with a better solution to encourage individuals to learn about investing while having a bit of risk-free fun with it. Those critics may be interested to learn, as we did, that even in the context of a risk-free simulation, some participants found that after playing with a leveraged ETF, the volatility and risk and daily swings was more than they were comfortable with and more than they could handle. In short, most investors believe they have a high-risk tolerance until the risk in the form of downside volatility is actually experienced.
Understanding that sometimes stocks just go up and down
We find investors are always looking for a reason for a stock move. If a company decreases or increases 1 per cent or 2 per cent, some sort of higher order answer is sought out, when the truth is sometimes stocks simply go up and then down. It could be due to a movement relative to the ebb and flow of the markets, it could be due to a large seller that just needed liquidity or there could have just been some counterparties that were slightly more eager to sell than the buyers. Public perception and human emotion are enough to move a stock by small amounts day in and day out.
You can't make money by sitting in cash
This is a great lesson on many levels. At face value, cash has a real opportunity cost. If you are holding it, you are missing out on returns elsewhere. You cannot become financially independent by sitting on the sidelines. Students learned that they the earlier they started, the better chance they have, which is maybe one of the most important keys to investing. Time is your friend in the markets and the longer one is invested, the better the probability they have of succeeding in the markets. The beautiful thing about learning this lesson in high school is the amount of time someone now has to learn, invest, make mistakes and hopefully fund a healthy retirement.
If you are an investor getting started on your journey, this short list is a great primer on things to think about and consider as you begin to structure a portfolio. If you are an industry veteran, these points remain classic reminders of the pitfalls that investors continually fall into over time. Things like selling too early and holding on to losers are cognitive issues psychologically hardwired in everyone, and market participants continually need to pinch themselves to ensure they are not repeating these primal errors. But don't fool yourself – there are still plenty of lessons and pitfalls to be aware of. We will cover the final five lessons you can learn from a high school stock simulation in a later article.
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In order to remain truly conflict-free, the writer and employees of 5i Research cannot take a position in individual Canadian equities.
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