Young & Invested: The three biggest ETF mistakes I’ve made
ETFs are simple products. Avoiding the mistakes that undermine returns is much harder.
Welcome to my column, Young & Invested, where I discuss personal finance and investing for Gen Z and Millennials.
This column aims to be a resource for young investors navigating an ever changing financial, political and social landscape as they try to build wealth. Tune in every Thursday for the latest edition.
Edition 76
I find a lot of personal finance content tends to suffer from survivorship bias. Most people are generally more enthusiastic about discussing their winners than their mistakes. In the interests of providing a public service, I thought I would do the opposite.
ETFs are often portrayed as a simple solution for investors and there is a lot of truth to that, but in my five years of investing in the products, I’ve still found plenty of ways to get in the way of my own success.
Overtrading
One of the most persistent mistakes I’ve made is overestimating the value of my actions. I’ve assumed the more decisions I made in my portfolio, the better my investment outcomes would be.
According to data sourced from the World Bank, the stock market turnover ratio of domestic shares in Australia was 49% in 2024. In comparison, the world average is around 34%, based on data from 67 countries.
Overtrading and consequently increasing the turnover of your portfolio is not a mistake that is unique to ETFs. If anything, ETFs are actually designed to facilitate the opposite behaviour. Yet in the past I found myself frequently reassessing holdings, considering new opportunities and questioning whether a different fund might produce marginal improvements.
There are a number of reasons we tend to tinker with our portfolios. When markets are volatile, new products are constantly being launched and investment narratives continue to dominate. Being inactive can almost feel negligent. There is always the temptation to equate the level of activity with progress. Though the evidence actually points to the contrary.
Much of the research on overtrading stems from the work of Brad Barber and Terrance Odean and their 2000 paper ‘Trading is Hazardous to Your Wealth’. The authors looked at over 60,000 brokerage accounts and sorted them into quintiles based on their portfolio turnover to determine the effects on returns.
The conventional view would suggest that the more active investors should have benefited from a greater level of engagement. Instead, the research found that before trading costs were taken into account, returns across the groups were quite similar. Whether they traded frequently or rarely, the gross returns were clustered within a relatively narrow range. The divergence emerged after trading.
The authors found that once costs like commissions and bid-ask spreads were accounted for, the highest-turnover investors underperformed the lowest-turnover ones by between 5.5% and 9.6% per annum.
Something that is interesting about this study is that it challenges a deeply held assumption about what leads to poor investment outcomes. We often attribute unfavourable returns to simply selecting the wrong investments, but the results of this study show that the more frequent traders were not necessarily making worse choices than their less active counterparts. Instead, the drag on performance came from the repeated pursuit of marginal improvements.
A lot of us act on the assumption that a different holding, strategy or opportunity will produce a better outcome, but as we see from the study, in aggregate these decisions often fail to generate sufficient benefits to offset the costs incurred in implementing them.
I think the most important lesson to take is that overtrading is not a failure in your depth of analysis or judgement. It is more a failure of behaviour. It’s easy to assume that every new piece of information warrants a response, even though in reality most information has little bearing on the long-term.
Looking back, many of the trades I made were not driven by a fundamental change in my investment philosophy. Rather, it was the belief that doing something was preferable to doing nothing.
Making tactical shifts
Another mistake I’ve made is attempting to make portfolio shifts based on my view of where markets are heading. This rarely involved making large changes or trying to predict short-term market movements, but it happened when there were periods I thought a particular risk wasn’t being acknowledged, or that valuations had become stretched and one part of the market was likely to outperform another.
The appeal of being tactical is obvious. Investing would be considerably easier if we could identify what was coming beforehand and adjust our portfolios accordingly. The challenge is that acting on this requires more than simply being directionally correct. We also need to get the timing right, twice. Once when making the change and again when choosing to reverse it. Any seasoned investor knows the dismal odds of executing this successfully, but it took some time before I realised that my confidence was out of proportion to my actual advantage.
ETFs make it remarkably easy to implement tactical views because we can express almost any market opinion in a single trade. I used to perceive this flexibility as an advantage, but the real question is whether it improves outcomes. Perhaps the clearest evidence against this assertion is the data on how professional investors have struggled to tactically allocate successfully.
Tactical allocation funds adjust their portfolio exposure to adapt and capitalise on changing market conditions. But the average US tactical asset-allocation fund has consistently underperformed more static asset allocation funds.
Tactical allocation is often presented as a middle ground between passive investing and market timing. Yet making strategic adjustments based on market conditions, valuation metrics or perceived risks still rely on the assumption that future market movements can be predicted with enough accuracy to improve outcomes.
Investment markets are the aggregate views of millions of participants. If professional investors with dedicated research teams have struggled to consistently add value through tactical shifts, it is worth questioning with an individual investor can reasonably expect to do better through rotating ETFs.
I don’t think taking a stance on the market is a worthless pursuit. What has changed is my willingness to reshape my portfolio around these views. Plenty of people are able to make entirely reasonable observations. The problem is that these reasonable observations do not automatically translate into profitable investment decisions.
Chasing past performance
The phrase ‘past performance is not a reliable indicator of future performance’ is enough to elicit an eye roll from anyone in the financial industry.
As humans, we are naturally inclined towards recency bias. That is, the tendency to believe what has recently occurred will continue to do so. What was once likely an evolutionary survival mechanism has grown into one of the biggest pitfalls in investing.
It is easy to mistake market momentum for a permanent state of affairs. The ETF industry makes this particularly challenging. Investors have access to a growing number of products offering exposure to whichever segment of the market is currently attracting enough attention. A strong year for AI, crypto or emerging markets is often followed by increased investor interest and inflows into ETFs targeting those areas.
An example of this was my investment in ARK Innovation ETF (ARKK) in 2021, which had returned over 150% in 2020 and was at the centre of tech enthusiasm. However, what goes up must come down. The narrative eventually shifted due to the concentration in unprofitable growth stocks amid rising interest rates. By late 2021, performance had deteriorated with many investors who piled in near the top (myself included) were left with significant losses.
To be clear, this is not a personal sob story about a bad pick going bust. If we look at asset class returns over the past 20 years, it’s clear how difficult it is to consistently pick winners and losers. Asset classes that lead one year frequently fall back the next, while previous stragglers unexpectedly move to the top of the table. That is why I’m always sceptical on building a portfolio or investment case based on yesterday’s optimism.
Source: Vanguard asset class tool.
Looking back, some of my poorer ETF decisions stemmed from treating strong returns as evidence that I should increase exposure. In reality, I was often responding to the same information that everybody else had already observed. By the time an investment theme becomes obvious, much of the optimism is frequently reflected in prices.
There will always be an ETF, sector or market that outperformed your portfolio over the previous year. Investing becomes much harder when we convince ourselves that we need to own whichever one that happened to be.
One of the more useful lessons I’ve learned is that every portfolio will appear suboptimal in hindsight. The objective is not to own whatever turns out to be the best-performing investment. It is to own a portfolio that can help you achieve your goals without requiring you to correctly predict what the next winner will be.
