As part of the financial industry for the past twenty-plus years I have seen a lot of things. Drawing on that experience, I thought it would be helpful to share with you a list of five of the most common investing mistakes I see investors make time and time again. It does not appear to matter whether or not the investor is wealthy, young or old, highly educated or less so. These mistakes seem to be universal and unflagging over time. My hope is, that by laying them out for you here, simply and without embellishment, you may have a better chance to buck the trend and avoid making them yourselves.
1. Investing Without a Goal in Mind –
You would never get on the freeway and drive without a destination in mind, right? Or start building your dream home without blueprints? So, why would you ever try to build your financial future without both blueprints and a destination in mind? Unfortunately, this is exactly what most people do. Investors often spend more time planning for their one-week summer vacation, than they do for their 30-plus-year retirement. This is a huge mistake! By starting with the end, or goals, in mind, and writing down your plan of action to get there (i.e. a financial plan), you force yourself to be systematic, methodical and unemotional in pulling off your investment strategy. This, in- turn, gives you the best chance of reaching those specific goals. And because you may have multiple goals, it is fine to have multiple strategies if need be. The key, though, is that no matter how many goals and strategies you have, always start with the end in mind, and never change your plans or strategies along the way based on emotions or gut feelings.
2. Not Understanding What Risk Really Is –
Most people think volatility is risk, and use the two terms interchangeably. But volatility is not risk. Volatility is the movement of your securities and/or portfolio, both up and down. Volatility is actually the way investors make money in the stock-market over the long run. Volatility is like wind to a sailor: it will not always blow in the direction you want, but you can’t get anywhere without it. On the other hand, risk, for most people, is the chance of not being able to meet your financial goals, such as retirement, funding a college education, or passing on a substantial inheritance to the next generation.
I often meet people who say, “I am getting older so I’d better invest more conservatively.” Or, “I don’t have much money, so I’d better invest conservatively, or maybe not at all.” They believe they are too old, or not wealthy enough to take on much risk. And, if it turns out that these investors have done proper planning and determined that they do not need growth to meet their goals, then I fully agree. However, if those same people have goals that they cannot reach without growth, or if the erosion of their purchasing power by the forces of inflation over time, poses a substantial threat to their future, then getting more conservative with their portfolio assets, or getting out of the markets altogether, may be the most dangerous move of all.
Of course, we would all like to see less downside volatility from our portfolios if possible. But, it is precisely the volatile swings in the markets, that dislocate asset prices and allow for long-term growth to be achieved at all. And if you need growth, regardless of your age or your asset base, you likely need to be invested.
3. Focusing on Security Selection Instead of Diversification –
It is widely accepted and often quoted in the financial services industry that 90% or more of a portfolio’s long-term performance comes from picking the correct asset allocation (i.e. diversification), and that less than 10% of the performance comes from picking the right underlying investments. In other words, how much you put into U.S. stocks, international stocks, real estate, bonds, etc. matters significantly more than which stock, mutual fund or exchange-traded fund you choose. However, most investors spend a majority of their time focusing on individual security selection. This make absolutely no sense. Yes, it is fun and exciting trying to pick individual securities, and it makes great conversation at a cocktail party, but it is actually the least important part of an investment plan.
Asset allocation and rebalancing are things that should be implemented and executed systemically, intelligently and without emotion. Picking the right security is most often driven by emotion (and often a false sense of skill) and is fraught with danger. Even so-called experts, who spend all of their time and energy researching stocks and the markets, on average, fail to outperform the markets or indexes they are tracking. So, why would someone with even less training and less time to devote to the task, think they would fare better? Focus on what you can control and what is most important (diversification) and forget about what is least important and most likely to go wrong (individual security selection).
4. Buying High and Selling Low –
The stock-market is the only market in the world I know of where people often prefer to pay more. What do I mean by this? When the stock market goes up, everyone is ready to pile in. When the market goes down, everybody wants out. It makes no sense, but for some reason, people just forget that the stock market, is just that, a market. Would you ever go to the super-market and look for whatever was most expensive? No, you wouldn’t; you would likely be more rational in the super-market. If avocadoes are $0.50 apiece, you load-up on avocadoes. If avocadoes are $3.00 each, you hold off buying until the price comes down. Or maybe you pick them off your neighbor’s tree and sell them! The stock market is a market just like a super-market. The only difference is that people are rational in one of them and often not so rational in the other.
5. Letting the Tax Tail Wag the Investment Dog –
Taxes are undeniably an important part of investing. And, whenever possible, all things being equal, we want to minimize or avoid taxes. However, avoiding and/or deferring taxes at all costs is not a good investment strategy. It’s important to remember that having to pay taxes generally means we’ve made money, so, if the goal is to avoid taxes no matter what, the simple answer is don’t make any money. That obviously doesn’t make any sense, but in practice, this is how people often behave.
Investors regularly refuse to sell or diversify their portfolios because they are worried about the tax consequences. But If their portfolio needs to be diversified, or if they need to take money from their portfolio to live, then letting the tax issues determine those choices is usually a mistake. Yes, minimize and defer taxes when possible, but don’t avoid making good investment decisions simply to avoid paying taxes. Doing so is like choosing not to put out the fire in your house, because you don’t want the carpets to get wet.
There you have it: my five most common investing mistakes for the average investor. If you can avoid those, you’ll be on the right path towards a healthy financial future.