1. Fear, Panic, Greed and Euphoria
During the latest bear market from November 2008 to March 2009, we all felt real fear. Our gut told us to run to the hills. From 1995 through 1999 we all felt euphoria during one of the great bull markets in history. Our gut told us to invest more and more money in the stock market. Unfortunately, our gut told us to do exactly the wrong thing at the wrong time in both instances. In fact, we must usually do the opposite of what our gut is telling us to do. It is okay to feel fearful and greedy, we just have to avoid making investment decisions based on those emotions.
2. Lack of Diversification
Betting too much on one stock, one sector, one idea, one strategy, one manager, one private investment, or one whatever is usually dangerous to your long-term financial health. You are playing Russian roulette with your portfolio. While great returns are possible, so are great losses. At some point, your portfolio may take a direct hit – and all you can do is hope that your long-term financial plans can survive. Lack of proper diversification is a risk that is not worth taking – and it is usually easy to avoid.
3. Investing with the Crowd
In 1999, many investors loaded up on tech stocks because everyone was supposedly earning unbelievable portfolio returns. In fact, many of these tech companies were actually losing money, but the allure of the crowd was undeniable. Investors were crushed when the bubble burst. The same can be said of “chasing returns.” For example, when all the “top performing” mutual funds are in the same sector at the peak of its cycle, a lot of money flows in only to experience subpar returns when the cycle turns. Disappointed in these funds, investors check the next list of “top performing” funds and move their money, and the cycle continues.
4. Letting Your Cost Basis Guide Your Investment Decisions
What you paid for an investment is not a determinant of its value – it’s only worth what someone else will pay you for it. Do not get emotionally attached to your investments, or refuse to sell them at a profit or a loss. If you are resisting selling an investment at a loss, remember that an investment will not always come back in price. In fact, it often goes lower. If you are resisting selling at a profit, remember not to let the tax tail wag the dog. By all means, reduce your tax liability, but not at the expense of your long-term goals and objectives.
5. Not Understanding Your Investments
In today’s complex investment world, there are literally thousands of different investments from which to choose. Some of these investments are more complex than others. The most complex investments are often hedge funds or other private investments. These investments should be approached with caution. Since they are more complex, they may not behave the way you or even the manager of the fund thinks they will (e.g. subprime mortgage CDO’s).
6. Speculating When You Think You Are Investing
Knowing the difference between investing and speculating is critical.
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7. Trying to Time the Market
This is a sure recipe for under-performance.
According to Morningstar, over the 20 years ending December 2008, the S&P 500 index averaged a gain of 8.4% a year. The average equity fund investor, however, gained only 1.9% a year over that time frame. Equity investors also under-performed over the prior three and five years.
For fixed income investors, the results were similar as the Barclays Capital US Aggregate Bond Index gained 7.4% a year for the past 20 years while the average fixed-income fund investor gained only 0.8% a year. Bond investors also under-performed the bond index over the prior three and five years.
Why? Because the average investor jumps out of the market when things are bad (usually at the bottom of the cycle); and they jump into the market when it feels right (usually at the top of the cycle). They change course frequently and usually at just the wrong times. They follow their gut. They chase returns.
From time-to-time, we are all seduced by the siren call of market timing. Resist the urge. It cannot be done consistently, and the Morningstar research above supports that conclusion.
8. Investing for Yield and Not Total Return
Many retirees believe that they should live off their interest and dividends and not touch principal. However, in order to generate sufficient income in today’s low-rate environment, some retirees are reaching for extra yield by investing in junk bonds and other risky income producing investments. Resist this thinking. Instead, consider the total return of your portfolio (which would include interest, dividends, and also capital appreciation). Also, consider the long-term effects of inflation on your portfolio. For many retirees, they will not be able to stay ahead of the game by focusing solely on income producing investments.
Over the last 80 years…
the Standard & Poor’s 500 has an average annual rate of return of 9.4%. In comparison, over the same period of time, long-term corporate and government bonds have averaged about 5.6% per year during the same period of time.