Individual investors often jump into the investing arena without having a financial plan in place. The risk? Committing common investing mistakes that end up lowering overall returns. Avoid the mistakes below and you’ll be equipped to make better investment decisions.
Mistake #1: No Investment Plan. You’ve heard it before; “If you don’t know where you’re going, how will you ever get there?” Don’t feel bad if you don’t have an investment plan. You’re not alone. Many professionals do not have a formal investment plan; even investment professionals managing money for others!
First, your portfolio should encompass all your assets and liabilities, including real estate, automobiles, and even less marketable investments such as art, stamp, or coin collections. The full spectrum of investments must be considered because the returns from all these investments interact, and these relationships impact the investment portfolio. Next, you need to consider your investment objectives. Third, a clear understanding of your time horizon and expected future return is critical to devising an investment plan that meets your goals. Finally, your tolerance for risk will play a large role in the types of investments best suited to you.
Mistake #2: Unclear Financial Goals. Just as you need a solid strategy in order to accomplish your business goals, you need a plan to reach your financial goals. And that requires a clear understanding of both short- and long-term goals across all aspects of your life. For instance, do you want a retirement home in Cabo? When and how much will you need to make that a reality? Do you plan to send your kids to college? How many kids, when, and what colleges? Is it important that you donate to charities – even once you’re retired? All of these considerations – and more – need to be figured into your plan.
Mistake #3: Imbalance between Risks and Expected Returns. Given a choice between two assets with equal rates of return, would you select the asset with the lower level of risk or the higher level of risk? While most people gravitate toward the lower level of risk, some take on too much risk without realizing the potentially devastating impact on their portfolio. You need to understand your tolerance for risk and how that fits into your overall plan. And you need to set realistic expectations about the returns you’ll realize. If you put your money into a certificate of deposit, the risks are low – and so are the returns. When you invest in BBB bonds, the risk is higher, but so are the potential returns.
Mistake #4: Lack of Diversification. A properly diversified portfolio – in other words, one containing assets with differing rate-of-return characteristics – should provide a more stable rate of return. If you are investing in Large, Mid, and Small Cap stocks and think you have sufficient diversification, think again! Even though your holdings represent different market-capitalized companies within the U.S., that’s not sufficient to minimize risk. In today’s market environment, the U.S. market indices are moving in the same direction. A well-balanced portfolio represents a variety of asset classes, investment styles, and markets – both domestic and international.
Mistake #5: Buying High. Don’t follow the herd and chase performance of hot stocks or market sectors. Yesterday’s winners can quickly become overvalued and correct to normal valuations – and that’s usually painful to one’s bottom line. Instead of chasing after hot stocks here and there, smart investors continually evaluate their investments in light of the current economic climate and adjust their portfolio accordingly. Of course, this strategy requires diligence and keen insight into a variety of market factors. You may be best served hiring a money manager who knows how to navigate the waters.
Mistake #6: Selling Low. We all know the old adage “buy low/sell high” but investors often lose sight of this. Don’t get greedy and watch your gain disappear. Similarly, do not hold on to losing assets hoping to make back your initial investment when you could be selling and buying assets that are moving up. It’s far better to cut your losses and shift assets into more promising investments.
Mistake #7: Getting Emotionally Attached to Investments. Too often, investors become emotionally attached to certain stocks and fail to sell – even when it’s painfully obvious that they should. Whatever the reason for holding on to a losing stock – sentimental attachment, pride and ego, or even denial – you’re only hurting yourself by holding through thick and thin. (If you’re thinking “But you just said to ride out market highs and lows”, keep in mind this is about individual stocks, not the overall portfolio). Remember a 25% decline takes a 33% increase to break even*. Review your investments on a regular basis and initiate corrective measures if necessary.
*If you invest $100,000 and your account depreciates by 25% to $75,000, you then need a 33.5% return to go from $75,000 back up to $100,000.
Mistake #8: Short-term Trading. If you are not trained in short-term trading techniques, do not adopt a short-term trading methodology. Successful short-term trading isn’t just a matter of logging on to an online brokerage account once in a while and buying and selling. It requires a significant investment in time and research, and a keen insight into market fluctuations and historical trends. Only the truly skilled trader succeeds in the short term. For everyone else, transaction costs and losses typically outweigh any gains.
Mistake #9: Setting Unrealistic Expectations. If your investments are spread across varied asset classes (as they should be), do not make judgments about one aspect of your portfolio based on the performance of a completely different investment. For example, don’t expect your bond return to be in line with returns on international markets. (It’s like comparing apples to oranges). The whole idea of a diversified portfolio is to minimize the risk from any single investment. So, by definition, your various asset classes should perform differently. Instead, compare each asset class to its associated benchmark.
By incorporating a few simple rules into your investing plan, you’ll avoid the common mistakes of investing. Remember – if you periodically update your plan and stay focused on your long-term goals, you should be pleasantly surprised at your returns.