Reacting to the media and its endless hype cycle is no way to manage your investments. Turn off the TV and tune out the panic. Photo: Dennis Skley
I recently came across a wonderful document published by the CFA Institute entitled Tips for Avoiding the Top 20 Common Investment Mistakes.
(The CFA Institute is the organization that manages the CFA, or Chartered Financial Analyst, certification program, which is an extremely robust certification for financial professionals, so much so that many other organizations simply accept that certification as a qualifier to bypass entrance exams and other certifications. Someone who is able to pass CFA exams knows their stuff.)
I often find myself disagreeing with materials produced by the financial planning industry, as most of their material is geared toward people signing up with a financial advisor, but I was more than pleasantly surprised by this document. It’s just as applicable to investors who are not using a financial planner as it is to people who choose to do so.
As I often do when I find documents like this, I start adding my own notes and thoughts all over the place, so I thought I would share the investment mistakes from the document along with my own notes on each mistake.
20 Common Investment Mistakes
Mistake No. 1: Expecting too much or using someone else’s expectations
Like it or not, the simple act of investing alone won’t solve all of your financial problems. It’s easy to think that because you’re now investing, everything will be perfect and all of your problems are solved. This is especially true when you listen to investment advisors who promise outsized returns.
I’ll give you a hint – you’re simply not going to beat the returns of the stock market over the long term, and probably not over the short term. People like Dave Ramsey suggest unrealistic expectations (he suggests a 12% average annual return, which isn’t based in any sort of reality).
The best thing for any investor to do is to keep their expectations within reality. Look at what the stock market actually does, not just in one year, but over a lot of years, and use those numbers for your expectations.
Mistake No. 2: Not having clear investment goals
For most people, this isn’t an issue – their goal with investing is to have a stable income in retirement to supplement their Social Security. This is about as easy as can be, with both employee sponsored and individual plans within easy reach of pretty much everyone. Most retirement plans make working toward that goal really, really easy by offering target-date retirement funds.
Where this gets tricky is when people are investing for reasons besides retirement. If you’re not investing toward retirement, you need to figure out exactly why you’re investing, how far off that goal is, and how much risk you can tolerate along the way.
Mistake No. 3: Failing to diversify enough
Diversification in investments simply means having your money spread across a lot of different things. Ideally, you’re spreading your investment money across completely different types of assets – cash, bonds, stocks, real estate, maybe even things like precious metals or collectibles.
The reasoning is easy – just because one of those things drops in value doesn’t mean that the others will, so if you have your money spread across all of those things, you won’t suffer if, say, the stock market takes a dive.
Some things even work in reverse: For example, historically, bonds do well when stocks take a dive and vice versa. The problem is that most people don’t diversify very much, especially when it comes to the things that are most important, like retirement savings.
Mistake No. 4: Focusing on the wrong kind of performance
The stock market can jump or drop multiple percentage points in a single day, and that can be a really bumpy ride for some people. If you have $100,000 in the stock market and it drops 4% in a day, you’ve just lost $4,000. That’s enough to make some people panic.
The thing is, if you’re invested in the stock market, the short term shouldn’t matter at all to you. What matters is the long term, and over the long term, the stock market has a fairly steady (although bumpy) upward trend. If you push the panic button because of one down day, or one down week, or even one down year, you’re going to end up hurting yourself big time.
Mistake No. 5: Buying high and selling low
Many people’s instincts tell them to buy stocks after a day or a week where they’ve done really well. Stocks have gone up 10% in the last quarter, they must be hot, I should buy in! Unfortunately, that’s buying high.
On the other hand, people often instinctively sell when an investment drops rapidly. They see losses over the last month or quarter and they get scared and panic. That’s selling low.
Buying high and selling low are strategies that are going to fail you over and over again. A much better approach: Ignore the lows and highs, buy a little bit each week or each month, and then sell when you need to.
Mistake No. 6: Trading too much and too often
Some people get really into the “game” of playing around with their investments. They’ll react to the news that they hear and move their investments around all the time. The problem when you do that is that you tend to generate lots of transaction fees as well as lots of tax implications.
Many brokerages charge you every time you buy or sell an investment, which can add up extremely quickly if you’re buying and selling too often. Those transaction fees chew up and swallow your gains quite quickly.
Beyond that, it can quickly turn your tax situation into a mess, with a mix of short- and long-term capital gains and losses that could result in a painful tax bill, too. You’re almost always better off making a diversified plan and sticking with it right off the bat.
Mistake No. 7: Paying too much in fees and commissions
Different brokerages charge different fees when you buy and sell investments. Not only that, commission-based financial planners like to get their piece of the pie, too. If you’re using a high commission planner and also investing in something that has high transaction charges, your money is going down the drain.
You’re far better off figuring out how to do these things yourself and finding investment opportunities that come with little or no transaction fees. I use Vanguard for almost all of my investments and if you invest directly with them and buy their funds, there are no transaction fees or commissions at all.
Mistake No. 8: Focusing too much on taxes
People often focus intensely on the tax consequences of their investment decisions, often to their own detriment. Yes, making a move to help you pay lower taxes can be a good thing, but the taxes a person pays on investment gains are often insignificant compared to having a good investment strategy for your goals.
If an opportunity comes up that can help you lower your taxes without losing investment gains, you should by all means take advantage of it, but if you’re making investment choices primarily to avoid paying a few dollars to Uncle Sam, like putting your money in a 401(k) with terrible options instead of a Roth IRA with great options so you pay fewer taxes this year, you’re almost always guaranteeing yourself a worse outcome.
Mistake No. 9: Not reviewing investments regularly
If you’re actually diversified into several different investments, some of those will have better returns than others in a given year.
Let’s say you want to maintain a 50/50 split between the two investments in your portfolio and, at the start of the year, you have $50,000 in each. However, during the year, the first investment goes up 20% while the second stays steady. You now have $60,000 in the first investment and $50,000 in the second, which is more like a 55/45 split.
If that keeps up, you’re going to be way off track. The solution is to check in on things every once in a while and then adjust your contributions to keep things in the balance that you desire.
Mistake No. 10: Taking too much, too little, or the wrong risk
Too much risk and you’re prone to panic and also to having a lower-than-expected balance at that moment when you want to make a withdrawal. Too little risk and you’re not going to get as much investment growth as you should.
If you’re not sure what to do, figure out your target date for your investments and look at what a target-date retirement fund for that date is doing, as that’s the kind of investment portfolio and level of risk you should be considering as a starting point.
Mistake No. 11: Not knowing the true performance of your investments
It’s great if some of your investments are doing really well, but that doesn’t mean that things are good overall. Your success isn’t judged on your best investment, nor is your failure based on your worst. What matters is that you know how everything is doing and that you keep them in balance by tweaking your contributions.
Mistake No. 12: Reacting to the media
The media always loves to hype things. The media also loves to hit that panic button hard.
One day, they’ll work to convince you that you need this or that investment because it’s the hottest thing in town. The next, they’ll tell you that everything is falling apart and the sky is falling.
Usually, neither one is true. The media simply knows that hype and fear are the things that attract viewers and readers. Be calm and measured – don’t fall for the media hype cycle, especially when it comes to your investments.
Mistake No. 13: Chasing yield
It is always tempting to jump into whatever investment happened to have the best returns during the last year or the last three years. If you see another investment similar to yours with a better return, why not jump to it?
First of all, past performance is not indicative of future returns. On top of that, the higher the yield, the higher the risk (in general). If you jump to a similar investment with a higher short-term yield, there’s a very good chance that the next year will be worse than what you already have, plus you’ll have to deal with transaction fees.
Mistake No. 14: Trying to be a market-timing genius
It is simply impossible to guess when the market is at a peak or when it is at the bottom of a decline. There is so much day-to-day variability in the stock market that guessing such things is essentially impossible. Of course, chasing that kind of market timing is going to trigger a bunch of transaction fees and absorb a bunch of your time. You’re better off just investing with automated regularity and not moving your investments around.
Mistake No. 15: Not doing due diligence
Just because some article suggested investing in something or some talking head on television said that a particular investment was amazing doesn’t mean that it is something you should be putting your money into.
Quite often, mentions in the media like that come from investment advisors that have their own financial reasons for hyping a particular investment, reasons that probably have nothing to do with your own financial success.
Be wary. Put in the time to research an investment by doing things like reading the prospectus or don’t bother investing in it at all.
Mistake No. 16: Working with the wrong advisor
Just as there is in any profession, there are good financial advisors and bad financial advisors out there. There are a few tell-tale signs of bad advisors, however.
One sure sign of a questionable advisor is that they’re not asking you a lot of questions – a good advisor wants to know who you are and what your reasons for investing are. Another sign is that they can’t explain why you would want to invest in a particular investment.
In general, I look for fee-based financial advisors, meaning that they don’t make their money from commissions on particular investments (because doing so would give them incentive to push you into those investments whether they’re right for you or not).
Mistake No. 17: Letting emotions get in the way
The worst investment decision is one based on emotions, and those emotions can come from a lot of places. They can come from fear about the future. They can come from anger or sadness regarding your key life relationships. They can come from irrational exuberance about how well things are going at the moment.
The best investment plan is one that’s considered with minimal emotion and one that you stick to throughout those emotional highs and lows.
Mistake No. 18: Forgetting about inflation
Inflation is a real thing. Prices continue to go up and up and up and if you don’t account for that down the road, you’re going to find yourself in a real pickle eventually.
Don’t make your target number match what you would need today. Include inflation in the equation. Assume that prices are going to go up (at least) 3% per year and thus you’re going to need that much more to live on in retirement. Yes, it makes the hill a lot bigger, but you’re better off shooting for the right number.
Mistake No. 19: Neglecting to start or continue
Many people avoid retirement savings because of a fear of complexity or a desire to maximize their paychecks today. Some people choose to discontinue their retirement savings because they feel pressured by today’s financial needs. The worst mistake you can make when saving for retirement is not starting at all; the second worst mistake is stopping your savings and not restarting it.
Mistake No. 20: Not controlling what you can
You can’t personally change the ups and downs of the economy, but you can change your own day-to-day behavior. You can choose to spend less on unnecessary things, which gives you more money to invest toward the future.
The key is finding a good balance, and many people believe in a balance that is tilted too hard toward the present and away from their future needs.
Five Key Steps to Address Most of These Concerns
So, how do you address these mistakes? What kind of plan exists that takes these widely varying mistakes into account? Here are five key steps you can take to address almost all of these issues.
1. Learn how to invest.
Knowledge is power. The most important thing you can do is learn, learn, learn and never stop learning.
Investing actually isn’t that complicated as long as you’re willing to spend the time to learn about it. I recommend picking up a really strong book on investing – my usual recommendation is The Bogleheads’ Guide to Investing by Larimore, LeBoeuf, and Lindauer – and read through it slowly.
At any point where you don’t understand a particular point, stop and go research that specific point until you do understand it. Any time a term comes up that you don’t quite get, stop and look up that term so that you do understand what’s being said. Look at lots of real world examples of what they’re talking about. Then, repeat this with another investment book or two. Before long, it won’t seem scary – instead, it’ll seem easy.
2. Manage the investments yourself.
Once you have that knowledge, managing your own investments seems like an obvious move. Why would you not manage your own investments if you understand investing?
Taking control of things yourself means that you don’t have to pay an investment advisor as a middle man between you and your investments and you also have the ability to freely choose whatever investments work best for you. Almost every investment firm offers more than enough online tools to handle personal management of investments.
3. Stick to a simple strategy.
The simpler, the better. Stick your retirement savings in a target-date retirement fund. If you’re saving for other goals, come up with a very simple portfolio spread across two or three different asset classes – domestic stocks, international stocks, bonds, cash, real estate, etc. – and just sit on that.
Set up an automatic investment plan and then just forget about the whole thing. Check it every once in a while and adjust your automatic investments accordingly so that you keep your portfolio in balance.
4. Ride out the ups and downs.
Stocks are going to go up and down. Bonds are going to go up and down. Real estate is going to go up and down. Don’t sweat it.
Never, ever forget that you are in this for the long haul and that making a panicked move based on a short-term drop or a short-term jump is probably going to put you in a worse long-term position, especially when you add in transaction fees and taxes (if applicable).
5. Call in a fee-based financial advisor only when you’re facing an exceptional challenge.
At some point, something will probably come up that is actually fairly complicated and you’re not sure how to proceed.
This doesn’t mean it’s time to panic or to undo everything. This means it’s time to call in a fee-based financial advisor, one who won’t spend their time trying to sell you on some investment option that isn’t in your best interests.
A good financial advisor will simply ask you a lot of questions, figure out where you’re going, and help you tweak things so that you stay on the path you want to be on. That’s what a good financial advisor does.
Final Thoughts
If you follow those steps, you’ll dodge most of these common investment mistakes just as a matter of course. These mistakes simply don’t apply to people who learn about investing, chart a simple course, and stick to it through the short term rises and falls.
The core to all of this, however, is learning about investing. Don’t trust everything to a financial advisor. Take the time to learn about investments on your own, even if you’re just depositing money in your 401(k). d to much better returns over the long haul.
Good luck!
The post 20 Common Investment Mistakes and Five Simple Steps to Avoid Them appeared first on The Simple Dollar.
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