Tip Content Provided By: Erik Carter, CFP® at Financial Finesse
Investing can seem complicated and even intimidating to a lot of people, but I’d argue that’s it’s actually the easiest part of financial planning. All you really need to do is make sure you’re reasonably diversified (there is no “perfect” here), keep your costs low, and stick to your plan through thick and thin. No hours of reading the Wall Street Journal or watching CNBC are required.
Here are the most common big mistakes I see people making, along with the 3 steps to avoid all of them:
1) Chasing past performance
Investments tend to go through cycles so buying whatever happens to be performing best will probably cause you to buy it closer to the top of a cycle then the bottom. If you sell it when it eventually under-performs, you’ll probably sell closer to the bottom. Repeat this enough times and you’re basically buying high and selling low, which is the opposite of what you want to do.
Even if you’re buying a top mutual fund within a particular category (which eliminates the effects of market cycles), studies have found that these top performers don’t maintain their edge. In fact, they often do worse than average. You would have done better by flipping a coin.
2) Trying to time the market
Instead of looking at the past through the rear view mirror, what about trying to invest based on what will happen in the future? This makes sense in theory, but in reality, the market is notoriously difficult to predict. You also have to be right not once, but twice. Even if you’re right about when to purchase an investment, how will you know when to get out of it? Professionals fail to consistently do this successfully, so do you really think you’ll be able to?
3) Not being diversified
Another mistake I often see is people having too much money in a single stock. After all, while the stock market as a whole tends to go up over the long run, a single stock can go to zero and never come back. This is especially dangerous if it’s your employer’s stock since your income is already tied to that company.
A good rule of thumb is to never have more than 10-15% of your portfolio in any one company’s stock. If you have stock incentives or an employee stock purchase plan, consider selling the shares and diversifying as soon as you can to stay within that limit.
4) “Diversifying” by randomly spreading money between all the funds in a retirement plan
The problem with this “diversification” is that you might not actually be properly diversified. For example, you can end up with 90% of your money in stocks if most of the funds available to you are stock funds. That might be fine if you’re an aggressive investor with a long time horizon but not if you are more conservative or have a shorter time frame to invest.
5) Being too conservative for a long time horizon
Being too conservative can actually be risky, not in terms of market volatility but the real risk of not achieving your financial goals. That’s because more conservative investments tend to earn as much over long time periods. Even a small difference of return can have a huge impact.
For example, $10k earning 2% over 30 years would grow to $18k, while at an 8% return, it would be over $100k. That’s a “loss” of over $80k that could have gone towards your goals.
6) Being too risky for a short time horizon
On the other hand, money that you need in the next 5 years should be invested very conservatively. That’s because investing it more aggressively puts you at risk of seeing the value of your investment decline and not recover in time. Don’t think it will decline in the next few years? Go back and visit mistake #2.
7) Paying too much in fees
One way to avoid these problems is to pay someone else to invest for you, usually through a mutual fund. The problem is that the fees that fund managers charge typically outweigh any value they provide. A Morningstar study found that low fund fees were the most dependable predictor of future fund success.
This is why Warren Buffett has repeatedly recommended that people invest in low cost index funds that simply track the market. In fact, he recently won a $1 million bet by a landslide that a simple low cost index fund would beat any group of hedge funds over a 10 year period.
3 simple steps to avoid these mistakes
- Make sure you’re properly diversified by taking a risk tolerance questionnaire and following the guidelines for your risk level, investing in a fully diversified fund like a target date fund, or using a robo-advisor that can design a portfolio for you.
- Implement your plan using low cost funds like index funds.
- Stick to your plan and rebalance about once a year to stay on track.
That’s it. The more you fiddle with it, the more mistakes you’re likely to make. Now go enjoy the rest of your money.
Have a financial question? Send it to Ask Financial Finesse.