The hidden costs of DIY Financial Planning: Bad Investments cost more than you think

Today’s Simple Investing Take-Away: Simple investing mistakes can result in bad investments that can derail your long-term financial goals and erode your emotional well-being. One of the biggest missteps, amplified by our behavioural tendencies, is to ignore the many hidden costs of DIY investing. Even if the price paid isn’t obvious, it still takes a toll on your results.

By Steve Lowrie, CFA

Special to the Financial Independence Hub

Eager to embrace DIY investing? Or have you at least wondered whether you’ve got what it takes to succeed on your own?

I understand the appeal. When you engage a personal financial advisor, you’ll see their advisor fees, loud and clear. The financial regulators require us to disclose them. Plus, at least here at Lowrie Financial, we want you to see them. How else can you tell if you’re getting a fair shake?

But therein lies a dilemma. Thanks to behavioural finance, we know about a multitude of murky costs that can slip in when investors allow their rational resolve and simple investing strategies to be hijacked by their complex instincts and emotions. Some of these self-inflicted costs include:

• The cost of chasing past returns by getting caught in a “fad” during up markets; or by panicking and selling out during scary times
• The cost of ignoring tax ramifications of frequent trading in taxable accounts
• The cost of investing as a form of entertainment, or experimenting with your financial future while learning the ropes

Once you factor in the bad investments and other prices paid by so many DIY investors, financial advisor fees start to seem well worth it. A reputable advisor should help you focus on your personal financial goals while avoiding these and other DIY investing pitfalls.

The cost of chasing Past Returns

Have you heard of “FOMO” or “Fear of Missing Out”? It’s that itchy feeling you get when you long to get in on a red-hot popularity contest, regardless of whether it fits into your financial plan.

Most recently, others seem to be making millions on all sorts of “silly season” exotica: from SPACs and Reddit-fueled stock runs, to cryptocurrency and NFTs. In real time, these may seem like simple investing decisions; jump on the bandwagon and make a ton of money, fast. Unfortunately, by the time you’re aware of a trend on a tear, you’ll be hard-pressed to buy in low enough, sell out high enough, and do both consistently enough to come out ahead in the long run. This means odds are heavily stacked against FOMO-driven investors who try to come out ahead (but usually fail) by chasing after winning streaks.

There are reams of academic inquiries pointing to the merits of more patient simple investing strategies for capturing expected long-term market growth. Recently, a University of British Columbia/Emory University study found (once again) that individual investors in Canada and around the globe tend to underperform the same stocks and markets in which they’re invested. Digging into why, the study’s co-authors found investors created extra self-inflicted investment volatility (nearly 50% higher) by piling into the market “after superior stock returns and before inferior returns.”

These findings only add to a volume of past studies into similar return-chasing adventures. By succumbing to FOMO investing and similar bad investment habits, DIY investors unnecessarily sacrifice available market returns.

The cost of ignoring Tax Ramifications

These days, many people are working from home, with more time to spend consuming financial media or social media forums. A simple look at these investing forums would lead you to believe that everyone from your co-worker, to your favorite sports hero, to popular financial gurus like Canada’s own Chamath Palihapitiya are supposedly seizing big profits and cutting losses in rapid-fire trades day after day. It seems so easy.

Again, if we look at the evidence, the after-cost, after-tax results usually fall short of a simple buy-and-hold approach. In a recent extreme example, a U.S. day-trader used $30,000 in cash, placing 10–50 trades daily, to come out $45,000 ahead in 2020. Not bad. Unfortunately, by failing to understand U.S. tax regulations, like the wash-sale rule, he also generated an $800,000 tax bill on the realized gains.

As this Morningstar article explains, a Canadian’s identical trades likely would have been more tax-friendly. Taxable gains may have been closer to “only” $300,000, with the ability to use loss-carryback rules to further reduce the bill. Still, clearly, without taking potential tax implications into account, day-trading can just as likely cost you, instead of making you money.

Even if you’re investing in ETFs rather than speculating in stocks, there are hidden tax traps there as well. For example, taxable “phantom distributions”. Explaining how this pitfall works is beyond the scope of this post. But the bottom line in this case is that you can end up paying tax on money you don’t actually receive. What is the benefit of saving money on a low-cost ETF, if you lose that advantage and then some on taxes? (An advisor can help you avoid these sorts of gotchas.)

The cost of investing for Entertainment and Education

Who needs financial literacy when you can get a simple investing app to enable and applaud your every transaction? Why bring in a personal financial advisor and pay investment management fees if you can instead swap success stories and commiserate over the market’s slings and arrows with your online peeps? Who knew investing could be so fun?

Unfortunately, using the markets as a form of entertainment can cause you to fall prey to other expensive behavioural biases, including overconfidence. This exposes you to the Dunning-Krueger effect, which means you basically don’t know what you don’t (but should) know to succeed as an informed investor.

The Wall Street Journal’s article “Robinhood Trader’s Battle Cry: ‘It’s All Just a Game to Me’” described how newbie traders have recently been competing with one another on social media to make the most money, the fastest, with the least understanding of financial economics. The article’s author, Jason Zweig, quoted one unemployed 22-year-old trader bragging on his TikTok videos: “When I tell you I don’t know what the f— I’m doing, I really mean it. It’s all just a game to me.”

I’ve posted on all this before: Three Things You and I Don’t Know About Investing and How Understanding Statistics Can Make You a Better Investor. Bottom line, treating the market as a source of entertainment often ends up being a very expensive way to amuse yourself.

What about those of you who are more thoughtful about your investing, but still learning the ropes? Your investment “education” can cost you real extra money without a financial advisor to coach you along the way. Important lessons are too often learned the hard way.

Those simple Investing mistakes can result in bad investments and Impact your long-term Financial Goals

DIY investing may sound like a great idea: Pocket those financial advisor fees, pick your own investments, and have some fun while learning how to do it. However, over time, the cost of that financial advisor can help you avoid some of the greater costs of bad investments, tax traps, and behavioural finance misjudgments that can imperil your financial future. Add them up, and those seemingly small DIY investing mistakes can become a big drag on your long-term financial goals.

Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on April 26, 2021 and is republished here with permission.