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How to Avoid the Worst Mistakes Investors Make

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Investing is about taking risks, and when you do that, you’re entitled to expect a return that’s commensurate with the level of risk you take. But if you’re not careful, your own mistakes can prevent you from achieving the return that should be yours.

In my all-day seminars I always discuss these traps, and I want to share them here. I have identified 18 examples, and I hope they will let you learn from other peoples’ mistakes so you won’t have to learn them yourself – the hard way.

Mistake No. 1: No written plan.

It always puzzles me why people who spend days planning a two-week vacation will make five-figure investment decisions seemingly on a whim.

A Fortune Magazine article published in 1999 says people with written plans governing their investments on average wind up with five times as much money during retirement as those without written plans.

Obviously, the act of writing a plan doesn’t put money in your pocket. But people who are methodical enough to put their plans in writing are also likely to do many of the other things that lead to successful investing. And of course, even the most brilliant plan is worthless if it just collects dust on a shelf.

With a plan, you can get back on course when you go astray. But without a plan, you can’t even know you’re off course.

If you don’t have an investment plan that’s right for you, developing one should be your top priority. If you’re a do-it-yourself type, visit our Web site and look in the Basics of Investing section of our Newsletter archives for an article called “Don’t Have an Investment Plan? Start Here.” Or get professional help from someone who does not sell financial products.

Mistake No. 2: Procrastination.

Waiting for the right time can ruin your results over a lifetime. Procrastination takes many forms. You don’t start saving for retirement until it’s nearly on top of you. You “know” you should review your investments but other things always seem more pressing. You think you’ll catch up later when the market is better, when you’re making more money, when you have more time.

And there’s the irony, because the longer you wait, the less time you have. Every day you delay is a day of opportunity that you can never, ever get back.

Mistake No. 3: Taking too much risk.

Investment risk is not a theoretical concept. It is the very real possibility, experienced earlier this year by many aggressive investors, that you will lose money.

Investing requires taking some risk, but many people take too much. They probably know that higher returns go hand in hand with higher risks. But they may believe they are immune from losses or that they’ll somehow know when it’s time to sell. The problem is that by that time, it’s usually too late. Their desire for high returns simply puts the blinders on.

Far too few investors understand the risks they are taking. Most don’t understand what could go wrong with an investment when they make it, and they have no plan for what they will do if things go wrong.

People who take too much risk often wind up being speculators instead of investors. But those who are savvy about risk invest instead of speculate. They never forget the importance of limiting and managing their risks. If they gamble, they do it with money they know they can afford to lose.

Mistake No. 4: Taking too little risk.

Some people are paranoid about the thought of losing any money at all. They want everything nailed down, secure, guaranteed. The sad truth is that absolute security is only an illusion. It doesn’t exist anywhere in nature and it certainly doesn’t exist anywhere in the financial markets.

Very low risk almost always equates with low return. If you put your emergency money in a bank account and earn 1 percent, you may think you’re taking no risk. But in fact you are taking the very real risk that inflation will rob your money of its purchasing power.

If you put your life savings in very low-risk investments, you are giving up an enormous opportunity. A few years ago my wife and I made $10,000 gifts to each of our three grandchildren for their retirement years.

When my grandson, Aaron, was six months old, we put the money into a variable annuity that will compound until he’s 65 years old. We did not choose the annuity’s money-market fund option, which at a compound rate of return of 5 percent would turn that $10,000 into $238,399 after 65 years.

Instead, we chose to invest the money all in equities, split equally between U.S. and international stocks. If I assume this combination can make a 12 percent return, by the time Aaron is 65 the account will be worth $15.8 million.

Had I gone for the no-risk option, I could have short-changed Aaron out of $15.6 million, or about 98.5 percent of his retirement. (For details of the arrangements we made for Aaron, see the following article: “The Best Investment I’ll Ever Make, or How to Turn $10,000 into $20 Million.” You’ll find it here: http://www.fundadvice.com/FEhtml/Parents/9408.htm. Along with that article you will find a link to a copy of the specific trust document we used.)

Mistake No. 5: Paying too much money to others.

Mutual fund investors essentially throw some of their money away by buying load funds instead of no-load funds. In addition, far too many investors pay far too little attention to annual expenses. Otherwise, they’d almost never buy annuities inside IRA accounts.

Expenses are like leaks in a bucket. The bucket is filled with your money, and you want the water level to grow. Everybody can understand what happens if a bucket has too many leaks in it. It’s a pity that investors can’t see that the same is true of expenses.

Mistake No. 6: Trusting institutions.

I often ask participants in my seminars if they trust their banks. Most of them are pretty emphatic in answering: No! But many of us act as though we do trust banks. We believe the bank will tell us if we should move our money somewhere else within the bank to get a higher return.

You and your bank have a classic conflict of interest. Your best interests are served by accounts that pay the highest interest, which at a bank is usually in a money-market deposit account or a certificate of deposit. But your bank’s best interests are served by accounts that pay you little or no interest on your money, like passbook savings and checking accounts.

It’s a mistake to rely on a bank to tell you what’s in your best interest. It’s a mistake to rely on a broker or a brokerage firm to tell you what’s in your best interest. The same is often true of insurance companies and government agencies, but that’s an entirely different topic.

Mistake No. 7: Believing publications.

“Best Funds for 2000 and Beyond”

“The 100 Best Mutual Funds”

“These Stocks are Real Steals”

“Got These Funds? Six Standouts You’ve Never Heard of”

Those are all real headlines from the covers of a popular personal finance magazine. Predictably, they prompt readers to grab the magazine and dive in, even if just out of curiosity.

Study after study shows that the majority of stocks and funds touted in such articles fail to do better than the average of other stocks and funds. But that doesn’t matter to the magazines, Web sites, radio and television shows and (I hate to admit it) newsletters that keep cranking out articles, broadcasts, lists and tips for eager investors.

Serious investors need textbooks more than hot ideas. But people don’t want textbooks. They want entertainment, and that’s what publications and broadcast outlets provide. Most of us don’t spend lots of time reading to educate ourselves. We prefer laughs, escape or relief from the stresses of daily life.

The right way to read financial articles that tout specific mutual funds and stocks is to treat them as useful sources of interesting ideas. The wrong way to treat such articles is to regard them as prescriptions of what you should do with your money.

Writers, editors and publications follow fads. They write about what’s in favor and in style. When the winds of popularity change, they are never far behind. That’s fine if you’re looking for entertainment. But it’s a poor basis for making investment decisions.

Mistake No. 8: Failing to take little steps that can sometimes make a big difference.

Some examples:

  • People fail to fund their IRA contributions at the start of the year.
  • People fail to make their annual IRA contributions at all.
  • People leave money in taxable accounts when it could appropriately go into IRAs and 401(k) plans and save taxes.
  • People don’t maximize their 401(k) plan savings.
  • People have multiple small IRA accounts, paying an annual fee for each one instead of consolidating them into an account large enough to avoid a fee in the first place.
  • People don’t move their money from a checking account to a money-market deposit account at a bank.
  • People don’t move their money from a bank money-market deposit account to a non-bank money-market fund.
  • Each of these little steps makes a difference. And over a lifetime the little differences add up to big differences – but only for people who take advantage of the opportunities they have.

    Mistake No. 9: Buying illiquid financial products.

    Liquidity is the ability to get your money back quickly, to turn an investment into cash. A stock is very liquid, because you can sell it whenever the market is open, and you’ll have your money three days later. Mutual funds are even more liquid, letting you have your money the next day.

    But liquidity is severely compromised when you invest in limited partnerships, for which there is often no market. When limited partners want to sell their units, they often find that everybody else wants out, too, and there are few buyers at any price. In this garage-sale mentality, the only buyers may be speculators who buy partnership interests for pennies on the dollar.

    Mistake No. 10: Requiring perfection in order to be satisfied.

    We’ve all known people whose attitude is that nothing is good enough for them. People who can’t stand to have anything but “the best” are rarely successful at investing.

    In fact, there will always be something that’s performing better than whatever you have. If you happen to have the one fund that outperforms everything else this month, you are practically guaranteed that some other one will be ahead of yours next month.

    Perfectionists often flit from one thing to the next, chasing elusive performance. But in real life, you get a premium for risk only if you stay the course. And if you demand perfect investments, you’ll never stay the course.

    Mistake No. 11: Accepting investment advice and referrals from amateurs.

    If you had a serious illness, I hope you’d consult a nurse or a doctor, not somebody on the street who had an opinion about what you should do. And I hope you would treat your life savings and your financial future with the same care as you would treat your health.

    Yet too many people make big financial decisions based on things they hear. “I heard this hot tip.” “I know somebody in this company.” “I’ve got an inside source about this new product.” “My broker is making me a ton of money.”

    The lure of the hot tip is all but irresistible to some investors eager to find a shortcut to wealth. Unfortunately, many investors have to learn the hard way that there are no safe shortcuts.

    A client once told me he had heard from friends about a woman who “made a lot of money” for his friends. My client, normally very conservative, cashed in $250,000 of his portfolio and turned it over to this woman, who said she would invest it in “a conservative strategy.” Within two months, she had lost half of the $250,000. Only then did my client learn she was not even licensed to do what she was doing. The woman’s compensation was to be 20 percent of whatever profits he made, giving her an incentive to generate big gains quickly. But he didn’t understand that until it was much too late.

    Mistake No. 12: Letting emotions – especially greed and fear – drive investment decisions.

    I think the two most powerful forces driving Wall Street trends are greed and fear. Think about these two emotions the next time you listen to a radio or TV commentator explain what’s happening in the stock market. You’ll hear fear and greed over and over.

    There’s fear of rising interest rates, fear of inflation, fear of falling profits. You name it, somebody’s afraid of it. Fear is why so many investors bail out of carefully planned investments when things look bleak – and since everybody seems to be selling at the same moment, prices are down. That, in turn, reduces profits or increases losses.

    Greed blinds investors, making them forget what they know. Last winter, greed prompted many inexperienced investors – and some experienced ones too – to stuff their portfolios with high-flying technology stocks, which had just had a terrific year. In the spring, technology stocks, especially the most aggressive ones, plunged without warning, leaving many of these greedy investors wondering what had hit them.

    Investors obviously want to make money. But this legitimate desire turns into greed when it runs amok. Likewise, investors obviously should want to avoid losing their money. But when a healthy respect for bear markets leads to panic selling, it’s out of hand and counterproductive.

    Mistake No. 13: Putting too much faith in recent performance.

    We tend to think that whatever just happened will continue happening. Sometimes that’s true, but a great deal of the movement in the stock market is random. And recent performance is a lousy predictor of near-term future performance.

    Ironically, recent performance is at the heart of the mechanical market timing systems we use and advocate. Our systems don’t predict the markets; instead, they identify and follow existing trends, on the presumption that those trends are likely to persist long enough to take advantage of them.

    Somebody asked me how we can use recent performance while we advise investors that it doesn’t mean much. It’s a good question.

    When we use recent performance in a mechanical timing system, we are using recent history as a tool. We have no emotional attachment to any part of that performance or our use of it, and we’re ready at any time to switch gears when our timing systems tell us to do so.

    Contrast that with an investor who identifies the hottest-performing mutual fund over the past year and who therefore buys that fund because he or she believes that hot performance means something (for instance that the fund has a brilliant manager or the “right” strategy) significant.

    Many investors get into trouble when they start believing in what they are doing. This belief tends to make investors put too much of their money into a single stock or one mutual fund. Such confidence takes a while to build up, and investors tend to make their commitments too late to fully participate in whatever it is that has impressed them so much.

    By this time, the investor’s emotional attachment has typically taken on a life of its own. Then when their favored investment starts falling behind, the investor’s confidence persists. By the time the investor is finally willing to admit that things have changed, he or she will have stayed much too long.

    As you can surely see, that is very different from the mechanical, unemotional way that we use recent performance in our timing.

    Mistake No. 14: Failing to resolve disagreements between spouses.

    It’s not uncommon for members of a couple to have quite different comfort levels and priorities for investing money. He may think she’s taking excessive risks; she may think he’s hopelessly conservative. Or of course it could be the other way around. When couples discuss finances, including investments, there are often power struggles going on under the surface. And when somebody is determined to “win” or to “keep the peace,” sound investment decisions often suffer.

    One spouse will give in or compromise, possibly with resentment. I’m reminded of a line in a song from the musical “My Fair Lady” in which Henry Higgins is complaining about the disruption a man feels when he lets a woman into his life: “Make a plan and you will find she has something else in mind, and so rather than do either you do something else that neither likes at all.”

    Mistake No. 15: Focusing on the wrong things.

    It’s generally agreed that asset allocation – the choice of which assets you invest in – accounts for at least 90 percent of investment returns. That leaves less than 10 percent for choosing the best stocks and the best mutual funds. But most investors focus at least 90 percent of their attention on choosing funds and stocks. Their energy would usually be better spent on asset allocation.

    Some investors also focus on small parts of their portfolios instead of the entire package. They can become obsessed with some small investment that seems to stubbornly refuse to do its part. Occasionally, an enraged investor will overthrow an entire strategy because of what happens to some small component of it.

    Mistake No. 16: Not understanding how investing works.

    Many people don’t understand diversification; they just know that it’s supposed to be good for you. They would be better investors if they learned how to put together non-correlated assets.

    The entire point of diversification is to always have some things in a portfolio that “aren’t working.” That’s because whatever is performing well at any given time won’t necessarily continue to do so. And you want some other asset class waiting in the wings to find its day in the sun, so to speak.

    Mistake No. 17: Needing proof before making a decision.

    The ultimate stalling tactic for those who aren’t ready to make an investment is to require one more piece of information or evidence.

    You can get evidence, but not proof. You can prove what happened in the past. But there’s no way to prove anything about the future except to wait until it happens.

    I think it’s ironic that the main focus of mutual fund advertising is past performance – yet that’s the one thing that the funds can’t sell and investors can’t buy.

    There are two track records for any investment. The first one just came to an end, and it includes all of history. It can tell you the range of returns and risks that are reasonable to expect.

    But it can’t tell you anything about the future. The second track record starts the moment you invest. It’s the only track record that matters to you, and it may or may not have any resemblance to the track record of history.

    If you really need certainty, stick to Treasury bills and certificates of deposit. But if you’re seeking returns higher than you can get from those, you will have to accept some uncertainty.

    The only thing you can be sure of about the future is that it won’t look just like the past. That’s why savvy investors hedge their bets, so to speak, by diversifying beyond what seems certain at any given moment. To be a successful, happy investor, you’ve got to somehow learn to live with the ambiguity of an uncertain future.

    How to overcome these common mistakes

    These mistakes are very common. If you recognize any of them in your own investing pattern, it doesn’t mean there’s anything wrong with you – just that you have room for improvement.

    The cures for many of these mistakes are obvious, though they’re not always easy to implement. They boil down to education, discipline and managing your emotions. Try the following suggestions:

    • Make sure you have a written investment plan that outlines what you must do to achieve your long-term goals. Use specific, measurable goals so you can “keep score” on your progress.
    • Educate yourself. Study the extensive article library at our Web site. Read a book or two from our site’s recommended list. For a refresher on the basics, read either “Investing for Dummies” or “Mutual Funds for Dummies”. Both are good.
    • If you don’t understand an investment, don’t put your money into it. I believe this single step will prevent more grief than almost anything else you can do.
    • Sometimes the best course is simply to slow down. Take a deep breath and apply a liberal dose of patience. Patience is probably the most under-rated virtue I know.
    • When you notice emotions are driving your decisions, substitute a discipline. If you have trouble doing that, consider professional investment advice or professional management.

    Now let’s have a little straight talk, just for the record. It might look as if I have a bit of a conflict of interest here because I manage money professionally for clients. That business provides the lion’s share of my income. And here I am in a newsletter advising do-it-yourself investors to consider professional management.

    My highest priority in this newsletter is to give readers the best information and advice I can possibly give them. I tell it like it is, and if I ever have to stop doing that, this newsletter will be history.

    From the start, FundAdvice.com has never hesitated to tell investors everything they need to know to do it themselves. If you can successfully put into practice what you learn here, and thus have no need for my management services, nobody will be happier about that than I am.

    But the plain truth is that successful investing – like successful dieting – is harder than it looks. I know this (on both counts) from plenty of experience. Again and again we’ve pointed this out. This issue is just one in a long succession of articles in which we have told readers how to avoid the pitfalls and successfully leap the hurdles.

    But sometimes education is not enough. Sometimes the smartest thing to do is hire a professional, either to advise you or to take on the day-to-day discipline of carrying out your strategy. If I didn’t point this out, I’d be doing you a disservice.

    So I’d like to leave you with a few thoughts about how to choose an advisor or a manager. Don’t do it casually, because they (perhaps I should say “we”) are not all alike.

    Choose a manager with experience. The vigor, idealism and enthusiasm of youth is wonderful. But there’s something very valuable about the experience that comes from having lived through good times and bad, having lived through market crazes and fads and having learned from mistakes. You are the one who will decide whether I’m merely promoting myself by making this recommendation. But I believe my more than three decades in this business makes me a better manager than I was when I started out.

    Choose a manager you can trust and with whom you are comfortable. This is totally subjective, but you are a human being with emotions that can derail you. Even if you find an advisor who is recommended by the world’s greatest authorities, unless this person wins your trust and confidence, he or she isn’t the right advisor for you. Rarely do I tell investors to follow their gut feelings, but this is an exception. This is not the only qualification you should pay attention to. But it’s an essential one. If you leave your advisor’s office feeling pressured to do something you don’t want to do, you probably have the wrong advisor for you.

    Choose a manager who will put your interests first. Your best bet is somebody who has no conflict of interest with you (because the manager doesn’t sell any products or have a financial stake in the specific choices you make). But if for some reason you can’t avoid a real or potential conflict, choose somebody who, in advance, openly discusses the situation to your satisfaction.

    Choose somebody who understands and is committed to whatever is important to you. Part of this is finding somebody who can help you discover and articulate the choices you will inevitably make. If the most important thing to you is avoiding the loss of your capital, don’t settle for somebody whose attitude toward that objective is only grudgingly lukewarm. And on the other hand, if what you want is flat-out growth with no holds barred, don’t go to somebody whose passion is designing bond portfolios.

    At the start of this article I told you I had 18 examples of mistakes, but I’ve listed only 17 so far. I have saved No. 18 as a “bonus” to readers who made it all the way through this long article.

    Mistake No. 18: Spending so much time focused on investments that “real life” gets crowded out.

    I’d like to repeat some thoughts from an article I wrote last winter for Alaska Airlines Magazine on the subject of what smart people do to prepare for retirement. (You’ll find the entire article on the Internet at http://www.fundadvice.com/press/alaskaairlines.html.)

    I’ve seen over the years that good retirement planning involves a lot more than just managing your money properly. Smart people take care of their health, both mental and physical. Smart people cultivate new relationships and nurture established ones. The happiest retired people I know are those who seem to have many favorite people in their lives, including people who are younger than they are.

    Smart people have plenty to live for. They have no trouble making a list of 100 things they would love to do if they had the time. And smart people don’t wait for retirement to make their dreams come true. They know life is uncertain, and all the tomorrows we assume are ours can be snatched away in an instant. Whatever their age, smart people find ways to make their dreams become reality, starting now.

    Paul Merriman is founder and president of Merriman Capital Management in Seattle and editor and publisher of http://www.FundAdvice.com. He is the author of two books on investing and writes a weekly column on mutual funds for CBSMarketwatch.com.

    How to Avoid the Worst Mistakes Investors Make
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