Thirty-Nine Reasons Why Amateur Investors Fail to Beat the Market Over Time 

When you read the title, did you think that it was just self-serving? Did you think, of course he would say that because the only thing he wants is to manage my money and wants to give all the reasons why I will fail to beat the market. Well, I thought you might think that and discount the reasons given below.  So I made sure that all these items came from researching the books in my library, written by those who have the empirical evidence to prove these points. They are true reasons. I know because of experience with a couple of them.

I hope you will seriously consider these reasons and use them to decide your future course, whether it be the investment of more personal time and effort, or whether it be the delegation of the management job to professional managers.
 

1. Time
The number one reason why amateur investors fail to achieve above-average returns is lack of time to do the job as it should be done. Investing requires constant attention and research.

2. Insufficient Research
Closely related to the lack of time, below, is the lack of thorough research. Thorough research takes a lot of time for each security. It is the most important point. If anyone wishes to beat the market, he or she must know more about a company than the market does. This is the main reason why men like Warren Buffett have been successful.

3. Not Reading the Books Before Investing the First Dollar
Remember Solomon's admonition? In all thy getting, get wisdom. Wisdom is the ability to make sound judgments based on knowledge. Knowledge comes from reading the classics on investing. Most amateurs take the short cut and commit their dollars before acquiring wisdom and knowledge.

4. Too Many Eggs in One Basket - Failure to Diversify
Studies show that over 90% of the return of a portfolio is due to diversification among asset classes. Specifically, the Brinson et al. study on 91 pension plans for the 10 year period from 1974 to 1983 found that 93.6 percent of the variation in those plan portfolios could be explained by the asset allocation policy. (Gibson, Roger. 1990. Asset Allocation-Balancing Financial Risk. Irwin. Chicago, Illinois. p.11 citing the article in Financial Analysts Journal, July-August 1986 entitled "Determinants of Portfolio Performance" by Gary P. Brinson, Randolph Hood, and Gilbert L. Beebower.) A major mistake is committing too much money to one or a few securities, particularly employer securities. Just ask an Enron employee.

5. Not Understanding Asset Allocation
Funds should be allocated among asset classes. General asset classes include domestic equities, international equities, bonds, preferred stocks, real estate or REITs, and cash. Within the equities class, there are value and growth classes. Within each of those classes are large cap, midcap, and smallcap categories. The main point of asset allocation is not about largecap, midcap, and smallcap. It is about spreading money among asset classes such as REITs, bonds, preferred stocks, international stocks, and cash that are not closely correlated to the movement of equity prices so that the whole portfolio is less volatile. 

6. Not Knowing When to Buy
Amateur investors do not pay attention to technical factors, both as to the individual security and the market as a whole. Amateur investors also tend to wait until a security has run up and is near a top, rather than buying when nobody wants the security. 

7. Ignoring the Margin of Safety Rule
The single principal that Benjamin Graham is remembered for is providing a margin of safety between the price paid and fair value (Graham, Benjamin.1973. 4th Ed. The Intelligent Investor. HarperBusiness) To follow this rule, amateurs must know how to value stocks, something they generally do not know how to do. Most professional investors who follow the value style of investing use GrahamÌs margin of safety rule, even if they don't apply it as mathematically rigid as Graham did.

8. Chasing Stocks
Closely related to the previous two, the amateur tends to buy when the stock has been running awhile, not wanting to "miss out" on the stock. Amateurs forget that stocks almost always retrace part of their advance, and those retracements provide better entry points. Amateurs believe prices will go up forever.

9. Not Knowing When to Sell 
Amateurs tend not to set a target sell price. Professionals always do. Amateurs tend to allow a loss to run, figuring the stock will always come back. Maintaining a sell discipline is one secret to investing success. Some believe that the time to sell is when the price breaks below support levels. Bill O'Neil believes the sell point comes when a stock goes about 8% below the entry price (O'Neil, William J. 2000. 24 Essential Lessons for Investment Success. McGraw-Hill. New York, NY p. 4). Others use a either a 10% or 20% rule. It's a matter of judgment and math. If you use the 8% rule, you can be wrong twice and right once if the right stock appreciates 20%, and still be ahead.

10. Trying to Catch a Falling Knife
Trying to guess when a stock will hit its low point is a losers game. Amateurs rush in too soon, before the stock has based or consolidated and started to move up on good volume. During the week of July 8, 2000 WorldCom fell below its 200-day average. After an anemic rise on low volume, during the week of September 8, 2000 it declined 19%. Today you can buy a share for 26 cents.

11. Failure to Use Stops
Amateurs do not use stops generally. In todays market, there should a limit to the downside, preserving profits and limiting losses. A stop loss order tells the broker to sell if the market price hits your limit price. Will Rogers said once: Its not so the return on capital that I am interested in as the return of my capital.Ó

12. Falling in Love with a Particular Stock
Ignoring the fundamentals can come back to haunt the amateur who clings to a stock because Aunt Jennie held it throughout her life, or the investor loves the product, name, business or something else that emotionally "chains" the investor to the security.

13. Buying Low-Priced Stocks
Amateurs are attracted to stocks under $10, particularly penny stocks because they are cheap and affordable. It is also seems easier for the $5 stock to double to $10, then a $50 stock to double to $100. Generally, low-priced stocks are riskier. A stock under $10 may have come down from a much higher price, and just because it is low does not mean it is a bargain either (remember Enron and WorldCom). Also, institutional investors such as mutual funds cannot or will not buy stock under $10, FidelityÌs Low-Price Stock Mutual Fund being the only exception. So there is no institutional following to support the price.

14. Ignoring the Charts
Many amateurs, and even some professionals, ignore the story the charts are telling. The market tells you what to do, and the chart technicals convey that message. Such technicals as moving averages, Bolinger Bands, the relative strength index, the advance-decline line, the MACD line, candlesticks, patterns, Fibonacci retracements, and Stochastics must be learned and studied. Learning candlestick charting takes time and study. The others are easier to learn. Now for a bold statement. If you don’t want to learn charting and technical analysis, you have no business buying individual stocks, period!

15. Ignoring the Time Horizon
When the invested funds are needed for some purpose within a period of three to five years, the amateur frequently ignores that fact and leaves the fund(s) invested in the equity market, exposing the portfolio to a greater risk of loss because the period is too short to make back any losses.

16. Expecting High Returns
Sooner or later the high growth companies fail to keep their early growth rates.The amateur usually misses the changeover, and winds up with a major loss after the stock falls off a cliff. Historical mean returns are 10% since 1929 which is made up of 7% real return plus 3 3/4% historical inflation. Fifteen percent is a more reasonable sustainable growth rate for individual companies. 

17. Not Paying Attention to the Numbers
Robert Olstein has run the Olstein Financial Alert Fund since 1995 and has never had a loss year, even during the bear market years. He does it by closely reading the financial statements and other disclosures in Form 10-Ks and avoiding accounting shenanigans and chicanery about which he has developed extraordinary expertise in spotting. Even then, approximately 20% of his investment choices don't work, and he unloads them quickly.

18. Buying Stocks of Businesses which are not Understood
Warren Buffett and certain other value managers do not buy tech and other complex stocks whose business models and potential for stable future cash flow are not understood. Amateurs buy anything going up, without understanding the business. If amateurs had read the reports of Enron, they probably would not have bought it. Exactly what the company did, what the business model was, was incomprehensible, even to the pros.
 
19. Buying Mediocre Companies
In Warren Buffett's world there are two types of businesses, the commodity-type business and the excellent business which Buffett calls a consumer monopoly, but in truth there is no such thing as a pure monopoly these days. There are oligarchies with a very few companies grabbing the lion's share of the market. Commodity-type businesses are those that are low-cost producers, have low profit margins, erratic profits, low returns on equity, no pricing power, an absence of any brand-name product, have multiple competitors, are in an industry with excess capacity, and have to make constant improvements to product(s). Such businesses are dependent on highly skilled, talented, intelligent, and innovative managers. The amateur investor may not appreciate the distinction Buffett makes, and as a result, will suffer subpar returns on investments in commodity-type businesses that were purchased unawares. (Buffett, Mary & Clark, David. 1997. Buffettology:The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor. Rawson Associates. New York, NY. pp 87-92.)
20. Paying Too Much
Amateurs usually do not know how to value a company. As a result they overpay in many cases. That cuts returns, or worse, results in a loss. Remember those Internet stocks?! Amateurs frequently make the mistake of rationalizing overpaying for an investment, telling themselves it is for the long-term. Overpaying for growth has been the cause of all major market bubbles, and their subsequent crashes and corrections. The key is knowing what the business would sell for, called intrinsic value, and paying no more than 80% of that price, preferably less than 80%. Richard Weiss, Strong Capital Management, likes to pay between 50 and 60% of intrinsic value (Kazanjian, Kirk. 2002. Value Investing with the Masters. New York Institute of Finance. Paramus, NJ 07652. pp 243-244). Amateurs usually do not know what the business or enterprise value is. Another reason amateurs pay too much is they buy the stocks that are in favor, as opposed to buying those temporarily out of favor. Wall Street is like a fashion shop. Eventually, the old fashions come back, and that's how the smart money invests. 

21. Failing to Kick the Tires
Peter Lynch's most memorable advice was to invest in companies you can visit, companies that are right under your nose, so to speak. That's good advice in so far as it can be applied practically. Also, shun mutual funds whose managers say they never visit companies because some of the information is biased, incomplete, or untrue. While there is an element of truth there, visits provide information not obtainable in any other way.

22. Becoming a Slave to Tax-Efficiency
There are very few stocks that can be held a long time without sacrificing return. In many cases, unfortunately, investors must choose between maximum return and minimum tax liability. High-dividend paying stocks are less volatile, especially during bear markets, and, sometimes, have better overall returns. However, they are not tax efficient because of the income. Also, holding a stock over 12 months to get a 20% tax rate can result in losing more in after-tax return if the stock declines by more than the difference between the marginal tax rate and the capital gain rate.

23. Over-Reliance on Newsletters
There are very few newsletters that beat the market. You can count them on one hand. Even the best newsletters recommend stocks that wind up losing value. Company-specific risk is ever present and no newsletter can eliminate it. Amateurs tend to accept recommendations without doing their own homework. The only impartial and widely recognized reviewer of newsletters is Hilbert's Financial Digest. Its cost is a bargain compared to the value it gives.

24. Over-Reliance on Analysts Recommendations
We now know that the analyst community's security recommendations should be regarded with a degree of skepticism. That's because they don't always tell us when to sell (remember the Enron and WorldCom debacles) and in certain instances have told us to buy when internal staff are telling selected clients to sell. We now know they are not always independent of the investment banking arm of their firms. We now know that management can pull the wool over even the analysts' eyes.

25. Over trading
Over trading hurts performance. According to a study of over 3 million trades between July 1, 1976 and December 31, 1976, women turned over (bought and sold) 53% of their portfolios while men turned over 77% of theirs. The women's return during that period was 1% higher than the mens. 

26. Failure to Understand True Growth
Growth in sales or revenues is the best measure of growth. Cost cutting, debt restructuring, reduced capital spending, layoffs, disposing of nonperforming assets and businesses, lower tax rates, and similar jiggering of the expenses do not produce sustainable, accelerating growth. If sales are not growing, sooner or later a stock's appreciation will stop.

27. Earnings Do Count
Part of the cause of the bubble of the 90s was the focus on a multiple of revenues instead of earnings. Investors were lulled and deceived into forgetting that a company with no earnings plus no prospects for earnings in the near future has no value other than the tangible asset value. Robert Shiller says that earnings and growth of stock prices do not correspond well (Shiller, Robert. 2000. Irrational Exuberance. Broadway Books. New York, NY. p.182). That statement can be misleading and misconstrued because it was made in a context of discussing the developing bubbles in stock prices. As a general rule, stock prices follow the trend in earnings. They are the prime determinative of stock prices, period, and anyone who follows the market closely will find that out. But it is not enough to recognize this fact. The amateur needs to invest only in companies where the earnings are reasonably predictable. That is rule #1 for Warren Buffett and who can argue with his performance. (Buffett, Mary & Clark, David. 1997. Buffettology-The Previously Unexplained Techniques That Have Made Warren Buffett the World's Most Famous Investor. Rawson Associates. New York, NY. p.24

28. Not Paying Attention to PEG Ratios
Another rule of thumb that was ignored during the late 90s bubble years is paying less than the PEG ratio for a security. The PEG ratio is the PE or price/earnings ratio divided by the growth rate. If the ratio is 1.00 or more, the investor is paying more than the growth rate, which doesn't make sense unless the bet is on an increasing growth rate.Generally, an investor would want to pay less than the growth rate because growth rates tend not to be sustainable. In addition, paying less than the PEG ratio allows for a margin of error.

29. Ignoring return on equity
Buffett figured that a reasonable return on investment should cover taxes and inflation as well as a return roughly equivalent to corporate bond rates. For him, that rate of return starts at 15%, and that's what he wants to see businesses earn on their capital. That's a pretty good rule of thumb. (Ibid. pp. 171-172)

30. Buying Stocks after a Recession has gone on for Six Months
No one can predict how long a bear market will last. Buying stocks during a recession in the hope of catching a bottom violates the "catch a falling knife" principal. Economies are unstable ships in a tossing sea. Wait until the sea calms and land is in sight. If this advice had been followed during the current recession, the investor would have "lost his shirt" during the spring of 2002.

31. You can't lose if you buy Blue Chip Stocks and put them in a Drawer
You can lose with blue chip stocks if you don't watch them periodically. General Electric is the only surviving member of the original Dow Jones Industrial average. During 2001 forty-four companies lost their place on Fortune's 2002 500 list. Enron was ranked 5th on FortuneÌs 2002 500 list. Ford Motor's profits declined 257% from 2000 (their stock declined also÷surprise, surprise)! WorldCom was ranked 42nd on FortuneÌs 2002 500 list. It probably won't be there next year.

32. Ignoring the Federal Reserve
One of the three responsibilities of the Federal Reserve Bank is to maintain stable prices, i.e. combat inflation. The Fed does this principally by trying to control the cost of money. They try to do that by raising the Fed funds rate and controlling the money supply. The Fed also tries to do the impossible÷fine tune the economy. They rarely succeed. When inflation rises above 3% heading for 5%, the Fed will act. When either the Fed acts or inflation rears its ugly head, stocks will suffer.

33. Ignoring the Efficient Market Principal
Amateurs believe that they can act on news that is old news and beat the market. Old news is news that has been public to investors for a few hours, a few days, but not a few weeks. The efficient market theory says that individual investors cannot beat the market because competing investors, particularly the professionals, act quickly and collectively value the stock properly. There are exceptions, but generally, I have found this principle to be true through experience. Stocks do not stay undervalued or overvalued for long periods of time. The amount of time that mispricing continues varies according to a number of factors, including but not limited to the size of the company, the number of analysts following it, the country of origin, and the number of mutual funds owning it. According to various studies cited by Robert J. Shiller in his 2000 book Irrational Exuberance, stocks with high price-to-earnings ratios and high price-to-book ratios tended to decline. That's good news for short-sellers who take advantage of mispricing of the upside and value investors who take advantage of mispricing on the downside. The question is: do amateurs recognize mispricing when it is staring them in the face? History says no. That's why the market has bubbles.

34. You can time the Market, can't you? 
No one can time the market, not even the professionals, although they seem to come closer. Selling at the top and buying at the bottom are impossible to execute accurately. Research shows that 80 to 90 percent of investment returns occur during 2 to 7 percent of your total holding period time. (Kazanjian, Kirk. 2002. Value Investing with the Masters. New York Institute of Finance. Paramus, NJ. p. 297.) Major market moves frequently happen in a few days, although the recent bear market has occurred over 27 months since March 2000. However, you can time the purchase of individual stocks by waiting for some bad news, which turns out not to be so bad after all and which the market overreacts to causing mispricing of the security.

35. Failure to use Dollar-Cost Averaging and Compound Interest
Amateur investors invest in globs of money, typically. They fail to understand the power of dollar-cost averaging and the compounding of interest principle. A constant investor who invests a set amount every month, through up markets and down markets, will become wealthy sooner than the investor who tends to invest in lump sums at infrequent intervals. Compounding of interest works better for the constant investor. 

36. Not using MPT Statistics when picking Mutual Funds
MPT stands for Modern Portfolio Theory, which in turn produces or gives us certain relevant statistics or standards on which to judge and compares mutual funds. If the amateur has access to Morningstar Principia, the statistics are available for each fund. One of the most important, in terms of comparing performance, is the Alpha or Jensen performance index. The formula is the difference between the realized portfolio return and the risk-adjusted required return. A positive Alpha means the portfolio manager did better than was expected, based on the risk-adjusted required return. This key measure is not found in newspapers or financial publications. The Morningstar rating sometimes is found, but Alpha tells which five-star fund was the best.

37. Valuation Foolspeak
Frequently, market pundunts will attempt to promote a security by disclosing the cash per share, the book value per share, and or the enterprise value per share. Typically, these statistics are trotted out when the market price has declined and is low relative to these per share stats in the attempt to infer that the security is a great buy at the recent quote. Amateurs are likely to fall for this. Why? Because they forget about earnings per share (if there are any), revenue growth, competitive position (is a competitor eating their lunch?), tough industry economics, accounting troubles, litigation problems, and a host of other factors that may indicate that the low price is not only justified, it could go lower.

38. Avoiding all high PE stocks
There is one exception and that is consumer monopolies. Warren Buffett likes consumer monopolies because they typically have high rates of returns for investors, they are in excellent businesses, they have pricing power to combat public enemy #1…inflation, they have high barriers to entry, other significant competitive advantages, they have higher than average profitability ratios, and they are usually financially sound. ( Buffett, Mary & Clark, David. 1997. Buffettology:The Previously Unexplained Techniques That Have Made Warren Buffett the World’s Most Famous Investor. Rawson Associates. New York, NY. pp 99-125)

39. Lacking passion to succeed at investing
You must have a passion to succeed in investing. You need to have passion because it will help you put in the hours, work hard, set goals, never become discouraged, stay in the game and be persistent, never stop learning, and continue to acquire more knowledge about the securities you own and analyze, analyze, analyze.