The Absolute Worst Mistake Investors Make -- And How To Fix It

Jimmy Butts's picture

Monday, September 8, 2014 - 1:45pm

by Jimmy Butts

Today, I'm going to tell you an unpleasant truth...

The vast majority of investors won't make much in their personal brokerage accounts this year... or next.

Now this might make you angry. But don't take my word for it, just look at a recent study done by investment-management giant BlackRock.

Its study illustrates that the average investor does poorly when compared to the growth of other asset classes like stocks, bonds and oil. in fact, as you can see in the chart below, the average investor earns just 2.1% -- below even the rate of inflation.

I didn't bring this up to poke fun. I want to point this out because the sooner we acknowledge that the individual investor generally fares poorly in stocks, the sooner we can begin to examine why and then take action to avoid some of the common mistakes made by most investors.

For starters, let's acknowledge a not-so-secret truth about the average investor -- very few know anything about how to value a security. Most of the research or tips individual investors get come from either A.) Friends, family members or acquaintances or B.) The talking heads on CNBC.

Take for example a recent conversation I had with my good friend, Roger. He knows I love the markets, so I knew he would inevitably ask the question... and he did: "So, do you have any good stock tips for me?"

Prior to joining StreetAuthority, I worked in the financial services industry as a financial advisor, so I've been accustomed to hearing these types of questions for years.

I used to thoroughly enjoy this question. It was a great opportunity to showcase all of the research and due diligence I had done on evaluating companies.

But my excitement wasn't always met with equal fervor.

People like my friend Roger would hear my long-winded take on a stock and would typically respond with: "oh... now what was the name of that company?"

Roger symbolized what most individual investors want -- the one hot stock pick that is going to make them rich... just handed on a silver platter without researching anything.

This leads me to the next reason why most individual investors fare poorly in the stock market.

The individual investor fails in risk management.

In other words, the average Joe tends to swing for the fences with every stock he invests in.

My colleague Andy Obermueller addressed this with readers in his growth-focused premium newsletter, Game Changing Stocks:

"The thing is, unsuccessful investors put all their effort and far too much of their asset base into chasing those big returns. They hear that a stock returned 100% and they want it. Another stock made 250%. They want it, too. They crave the big winners.

Then the news comes: The market created a 10-bagger. Many investors cheer such news, but these investors are crushed by it. They're completely dejected. Inconsolable. They didn't own the 'It' stock. But they WILL find it. They take more and more risk, investing in less and less suitable long shots, trying to find the next stock to be on the news. That's their goal. That's why they invest."

All too often, investors become so fixated on chasing the "home run" that they risk turning possible success into big losses.

Now don't get me wrong, it's still OK to swing for the fences. But to do that, I recommend following the advice Andy gives readers of Game Changing Stocks.

Andy suggests going for triple-digit gainers with the "20 Percent Solution" in mind.

His advice is based on a simple principle that was developed in the early 1900s called Pareto's Principle.

Its origins date back to 1906 in Italy, where economist Vilfredo Pareto observed that 80% of the wealth was controlled by 20% of the population. Pareto reportedly developed the principle after observing similar scenarios in everyday life, including the fact that 80% of the peas in his garden came from only 20% of the pea pods.

This principle has since been observed across a variety of disciplines.

For example, studies have shown that 80% of a company's profits often come from 20% of its customers. If you take a close look in your closet, you might find that you wear only 20% of your wardrobe 80% of the time. Because of this, many people, from management experts to fitness gurus, sometimes call this "the 80/20 rule."

Andy believes that 80% of you returns will probably come from 20% of your holdings -- that's the essence of his "20% Solution" strategy.

Let me explain...

Successful investors diversify based on their risk/return profile. Their idea of success is not to knock the cover off the ball, but to make consistently solid returns in line with their reasonable expectations.

The 20% Solution increases your exposure to higher return stocks but minimizes the risk.

To better explain, let's look at an example.

Let's say you put 80% of your assets into a low-cost index fund that mirrors the S&P 500's performance.

Historically, the S&P 500 index has averaged around 10% a year, including dividends. So by investing 80% of your portfolio in an S&P 500 index fund, over time you could expect a return of around 8% per year.

With the other 20% of your assets, you could devote a couple of hours every week to finding stocks with the potential to generate returns in excess of the market average -- like some of the investments Andy recommends in Game-Changing Stocks.

If you've done the proper research, many of these home-run stocks could do well. As we mentioned in a previous issue of Insider, Andy has been known to find stocks that have gained 373%, 442% or even 569% in the past.

Of course, there will always be investments that lose money, but let's say that this aggressive 20% of your portfolio nets a return of 25%.

That would juice the overall average annual return of your portfolio to 13% per year in this example.

That doesn't sound like much, but over time the added boost from the aggressive 20% of the portfolio can make a world of difference.

Let's look at the numbers. If you were to invest $25,000 in the S&P 500 and earned 10% annually, your investment would grow to $301,423 in 25 years.

Not bad, but if you instead used the 20% Solution -- investing 80% of your money in the S&P 500 index fund and 20% in aggressive stocks -- and your average return were 13% per year, that would be enough to turn a $25,000 investment into $633,596 over the same time period...

As you can see, you would earn more than twice as much money in 25 years in this example, just by moderating your high-risk investments to 20% of your portfolio. That way the majority of your money is in safer, large S&P 500 stocks, but your overall portfolio returns are buoyed by the more aggressive stocks.

By keeping Andy's 20% Solution in mind, you can dramatically increase your returns and prevent losing your shirt in the process... and have a good chance of beating the average investor's returns.

Note: If you're looking to use Andy's 20% Solution and load up on "home-run" stocks that could take your portfolio to the next level, then you'll want to check out his latest Shocking Investment Predictions For 2015. Simply put, Andy's report is chock full of ideas that could easily deliver triple-digit gains within the next year. To learn more, go here

Jimmy Butts does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.