There are seven common mistakes made repeatedly by investors.
Unfortunately, investors have been making these same mistakes since the
dawn of modern markets and will likely be repeating them for years to
come.
You can significantly boost your chances of investment
success by becoming aware of these typical errors and taking steps to
avoid them. In this article, we'll show you these seven mistakes and
how to avoid them.
No plan
As the old saying goes, if you don't know where you're going, any road will take you there. Solution?
Have a personal investment plan or policy that addresses the following:
Goals and objectives
- Find out what you're trying to accomplish. Accumulating $100,000 for
a child's college education or $2 million for retirement at age 60 are
appropriate goals. Beating the market is not a goal.
Risks - What
risks are relevant to you or your portfolio? If you are a 30-year-old
saving for retirement, volatility isn't (or shouldn't be) a meaningful
risk.
On the other hand, inflation - which erodes any long-term portfolio - is a significant risk.
Appropriate benchmarks - How will you measure the success of your portfolio, its asset classes and individual funds or managers?
Asset allocation
- What percentage of your total portfolio will you allocate to US
equities, international stocks, US bonds, high-yield bonds, etc. Your
asset allocation should accomplish your goals while addressing relevant
risks.
Diversification
- Allocating to different asset classes is the initial layer of
diversification. You then need to diversify within each asset class. In
U.S. stocks, for example, this means exposure to large-, mid- and
small-cap stocks.
Your written plan's guidelines will help you
adhere to a sound long-term policy even when current market conditions
are unsettling. Having a good plan and sticking to it is not nearly as
exciting or as much fun as trying to time the markets, but it will
likely be more profitable in the long term.
Too short of a time horizon
If
you are saving for retirement 30 years hence, what the stock market
does this year or next shouldn't be the biggest concern. Even if you
are just entering retirement at age 70, your life expectancy is likely
15 to 20 years! If you expect to leave some assets to your heirs, then
your time horizon is even longer.
Of course, if you are saving
for your daughter's college education and she's a junior in high
school, then your time horizon is appropriately short and your asset
allocation should reflect that fact. Most investors are too focused on
the short term.
Too much attention given to financial media
There
is almost nothing on financial news shows that can help you achieve
your goals. Turn them off. There are few newsletters that can provide
you with anything of value. Even if there were, how do you identify
them in advance?
Think about it - if anyone really had
profitable stock tips, trading advice or a secret formula to make big
bucks, would they blab it on TV or sell it to you for $49 per month? No
- they'd keep their mouth shut, make their millions and not have to
sell a newsletter to make a living.
Solution? Spend less time
watching financial shows on TV and reading newsletters. Spend more time
creating - and sticking to - your investment plan.
Not rebalancing
Rebalancing
is the process of returning your portfolio to its target asset
allocation as outlined in your investment plan. Rebalancing is
difficult because it forces you to sell the asset class that is
performing well and buy more of your worst performing asset classes.
This contrarian action is very difficult for many investors.
In
addition, rebalancing is unprofitable right up to that point where it
pays off spectacularly (think US equities in the late 1990s), and the
underperforming assets start to take off.
However, a portfolio
allowed to drift with market returns guarantees that asset classes will
be overweighted at market peaks and underweighted at market lows - a
formula for poor performance.
Solution? Rebalance religiously and reap the long-term rewards.
Overconfidence in the ability of managers
From
numerous studies, including Burton Malkiel's 1995 study entitled,
"Returns From Investing In Equity Mutual Funds", we know that most
managers will underperform their benchmarks. We also know that there's
no consistent way to select - in advance - those managers that will
outperform. We also know that very, very few individuals can profitably
time the market over the long term. So why are so many investors
confident of their abilities to time the market and select
outperforming managers?
Fidelity guru Peter Lynch once observed,
"There are no market timers in the 'Forbes' 400'." Investors' misplaced
overconfidence in their ability to market-time and select outperforming
managers leads directly to our next common investment mistake.
Not enough indexing
There
is not enough time to recite many of the studies that prove that most
managers and mutual funds underperform their benchmarks. Over the
long-term, low-cost index funds are typically upper second-quartile
performers, or better than 65-75% of actively managed funds.
Despite
all the evidence in favor of indexing, the desire to invest with active
managers remains strong. John Bogle, the founder of Vanguard, says it's
because, "Hope springs eternal. Indexing is sort of dull. It flies in
the face of the American way [that] 'I can do better.'" Solution?
Index
all or a large portion (70-80%) of all your traditional asset classes.
If you can't resist the excitement of pursuing the next great
performer, set aside a portion (20-30%) of each asset class to allocate
to active managers. This may satisfy your desire to pursue
outperformance without devastating your portfolio.
Chasing performance
Many
investors select asset classes, strategies, managers and funds based on
recent strong performance. The feeling that "I'm missing out on great
returns" has probably led to more bad investment decisions than any
other single factor.
If a particular asset class, strategy or
fund has done extremely well for three or four years, we know one thing
with certainty: we should have invested three or four years ago. Now,
however, the particular cycle that led to this great performance may be
nearing its end.
The smart money is moving out and the dumb
money is pouring in. Solution? Don't be dumb. Stick with your
investment plan and rebalance, which is the polar opposite of chasing
performance.
Conclusion
Investors who recognise and avoid
these seven common mistakes give themselves a great advantage in
meeting their investment goals. Most of the solutions above are not
exciting and they don't make great cocktail party conversation.
However, they are likely to be profitable. And isn't that why we really
invest?
