Sometimes the easiest path to success is to avoid the common mistakes made by others. When they are tinged with emotion, and are made without consideration of a guiding philosophy, bad decisions often seem to make perfect sense. And investing mistakes aren’t so obvious because they are clouded by the glut of information and “wisdom”.
Fortunately, the CFA Institute, an organization which administers the Chartered Financial Analyst (CFA) program, polled its members on some of the most common and costly mistakes made by individual investors.
No investment strategy – The first step for every investor should be to develop a framework to guide future decisions. Start with your objectives and add a strategy that reflects your tolerance for risk. Then consider the time frame, the available assets and future contributions. With this framework as a foundation, you are less likely to be influenced by fads and hype. As the cliché goes, if you fail to plan, you plan to fail.
Lack of diversification – A successful portfolio is most likely to contain several asset classes such as cash, bonds, stocks and real estate. Even within an asset class, such as stocks, diversification is critical to avoiding risk specific to a company or industry. It is very difficult and expensive to build a truly diversified portfolio with individual stocks, with studies showing that it requires at least 30 to 40 stocks to significantly reduce risk.
So why not just use mutual funds, since diversification is one of their main advantages? Because simply choosing a number of funds could still lead to portfolio overlap. (This problem became very apparent in the technology bubble when various funds from the same company were concentrated in the same stocks even though the fund names suggested they were in different areas of the market.) To make matters more complicated, choosing many funds can lead to higher costs and over-diversification. Even using index funds doesn’t necessarily solve the problem; for example, a large company growth fund will own stocks that are found in an S&P 500 Index fund.
Buying high and selling low – Ignoring the fundamental principle of buying low and selling high, many investors find themselves “chasing performance” and choosing those areas that have performed well over the last several periods. Of course, the cyclical nature of all investments soon kicks in and these investors find themselves with losses. Historical valuation levels and dollar-cost averaging are good tools to avoid buying high.
Selling low afflicts two types of investors: the impatient ones who think every investment should always be “doing something” and want to bail out at the first sign of decline, and the too patient ones who won’t sell until they recoup their losses. Have a sell strategy that is in line with the overall strategy and remember that it is better to take the loss and redeploy the assets than to hold on to blind faith.
Acting on impulse – Tips and media soundbites are notorious for being stale ideas on which investment professionals acted long before (see buying high). The reality is that the professionals make money by taking risks before the potential is readily apparent. Investing on tips or “trends” may be appropriate for the risk capital portion of a portfolio (a polite term for the money you are willing and able to lose).
Likewise, avoid investing in a stock and instead invest in a company by understanding the fundamental issues affecting a company and its industry. This will protect you from jumping into an investment based solely on market momentum or the company’s product or service (Krispy Kreme, anyone?)
Ignoring costs – Mutual fund expense ratios, transaction costs, management fees, service fees – it is increasingly difficult to fully identify all the costs associated with building and managing a portfolio. But you should be persistent in understanding the costs, and any potential conflicts of interest created by these costs, before opening an account. And resist the temptation to frequently trade. While discount brokerage commissions may be low, research still shows that a long-term diversified portfolio is more likely to perform better than active trading.
Avoiding the taxman – The objective is to make sound investment decisions, not to avoid all taxes. While it is important to understand and consider tax implications, it is much better to take the gain and pay the taxes (especially with the current capital gains rates) than to risk losses in the future.
Unrealistic expectations – The pendulum has swung from the unbridled optimism of the late 1990’s to the gloomy pessimism of the last few years. The long-term outlook, of course, is somewhere in the middle. According to Ibbotson Associates, stocks posted a compound annual return of 10.7% from 1926-2001 (4.7% after taxes and inflation) and long-term bonds posted returns of 5.3% over the same period (0.6% after taxes and inflation). Besides returns, expectations should consider the inevitable short-term ups and downs of investments in a long-term strategy.
Neglect – Once your strategy has been implemented, you still can’t simply put it away for the next 20 years. Your circumstances, objectives, assumptions and risk tolerance will undoubtedly change over time and your strategy should incorporate these changes. An annual review is the best way to keep your program on track.