And How To Avoid Them!
Because I review hundreds of investment plans every year, I see the same mistakes being made over and over again. Even though most of these mistakes are fairly easy to fix with the right plan in place, I still see my clients falling victim to these errors.
When I meet with prospective clients, they are more concerned about their investments than anything else related to their finances. They ask questions like, “Which funds are better to invest into? Should I buy technology stock? Should I be in the healthcare sector?”
Even though these concerns are warranted, there are much bigger problems that need to be addressed first, such as knowing how much risk you are taking. Even worse, the bigger mistakes are the ones you don’t even see! When it comes to retirement investing, serious missteps can cost you. Reviewing these common mistakes below will likely help guide you toward a more financially secure retirement.
Mistake #1 – Not taking a long-term approach with investing
Investing and wealth building is a marathon and not a sprint, and I can’t say this enough. Long-term investors are like marathoners in that they must be well prepared, resilient, disciplined, and focused in order to complete the race. Sprinting, like short-term investing, is a different sport.
A sprint is usually won or lost by how well runners respond to the starting gun and exploding off the blocks. In order to get ready for a quick sprint, sprinters like to pump themselves up, so their emotions are running high. Short-term investors’ emotions can run just as high, and some end up panicking when the market sells off. They usually are also checking their portfolios constantly and trading in and out of the market, trying to make a quick profit.
The marathon runner, however, puts in all their hard work up front prior to the big race, in the form of physical, mental, and psychological training and preparation. The long-term investor does the same thing. Before an investor embarks on a twenty-year program, he must carefully think through his investment objectives and goals. They will also determine things such as proposed return, risk tolerance, and liquidity needs before arriving at conclusions.
Okay, let’s race! Assume you’re the marathoner. You’re well-prepared, calm, and confident. You’re not focused on monthly or quarterly dips and peaks of the market, but you may need to make some minor adjustments along the way.
Your mission is to finish the race, not necessarily to come in first. You may need to slow down or pick up the pace as you go, just as you should be rebalancing your investment portfolio in a disciplined fashion. If you check your watch too frequently, though, you risk losing focus on the critical long-term goal.
Mistake #2 – Not understanding the risk you are taking with your money
I usually ask a new client how much risk they think they are taking, and almost every time their answer is way off base. I have met with investors who have stated that they had 60% in equities to find out later they have 80%. I have also met with investors who think they have 60% in equities yet only have 40%. Forty-two percent of investors don’t know how their assets are allocated in their portfolios, according to a recent Prudential Investments retirement preparedness survey.
This presents a huge problem because in a study conducted by Gary P. Brinson, CFA, Randolph Hood, and Gilbert L. Beebower (known collectively as BHB) – where they sought to explain the effects of asset allocation policy on pension plan returns – they determined that at least 90% of the variance in a diversified portfolio’s returns are attributable to asset allocation. The other 10% of your return comes from the selection of investments you make, such as individual stocks and bonds. This means if you earn a 7% rate of return in any given year, that 6.3% of that return came from the mix of how much money you have in equities, bonds, and cash. The other .7% return comes from selection (i.e., the funds or stocks you purchase inside your investment account).
What’s surprising, however, is that almost everyone I speak with mistakenly only focuses on the 10% of the total return you can earn by trying to pick the best individual securities. Don’t make the mistake of spending all your time trying to make decisions that won’t end up impacting your overall return. It makes no sense. How can a regular investor choose the right investments for his or her portfolio? There are tens of thousands of individual stocks, individual bonds, exchange-traded funds, open-end mutual funds, and closed-end mutual funds. It’s daunting and this is why you need to consider a framework or strategy to guide you. Asset allocation and choosing the proportional mix of stocks and bonds within your portfolio can provide this framework.
Spend your limited time and resources determining your correct asset allocation. Choosing the right asset allocation seems easy in retrospect, but a lot can go into determining this important mix. I first run cash flow scenarios for my clients. These scenarios must encompass their income, expenses, planned savings, expected returns, and an inflation rate. When you put all these numbers together, you can see the value of your portfolio assets per year.
Let’s say I run one of these scenarios, and the numbers show the client will have $2 million at retirement. The inflation rate is 5%, and the average rate of return over time was 7%. This means there is a 2% real rate of return (7% – 5% = 2%). Essentially, this same client could earn only 5% if there was a 3% rate of inflation (5% – 3% = 2%) over time, and they would still realize a 2% real rate of return, resulting in accumulating the same $2 million at retirement.
To determine asset allocation, I would look back in history and see what asset allocation has presented a 7% nominal average return over time. History would tell you that in order to achieve this rate of return, the asset allocation that could most likely meet your goals would be a portfolio where you invested 20% of your money in cash, 20% in bonds and real estate, and 60% in equities.
Obviously, there are other things you should consider when determining your asset allocation, such as your goals, the number of years you have to invest, and your risk tolerance. However, without running these cash flow scenarios, you are throwing a dart aimlessly. You must be clear about which growth rate will make your money last your lifetime and beyond, especially if you’d like your money to be given to others after your passing. Once you are clear on the rate of return you need to earn to propel your assets to last throughout your lifetime, then you can determine asset allocation.
Mistake #3 – Not knowing what you own
When you don’t know what you own in your investment portfolio, you run the risk of not being in suitable products and not meeting your long-term financial goals.
The only way to get really clear about what you own is to create a net worth statement. This is easily the most important number to understand. To get a precise picture of one’s physical health, a person will usually weigh themselves on a scale. A net worth statement is similar in that it provides a current snapshot of your financial health. It’s important to track this every year to make sure your wealth is moving in the right direction. If you are building an emergency fund, paying off student loan debt, and investing your money for retirement, you will see that your assets will increase, and this will reflect in your net worth statement.
To calculate your net worth, you need to add up all your assets and subtract your liabilities from the total (Net Worth = Assets – Liabilities).
Net Worth Cheat Sheet
- Make a list of all your assets: This includes your house, car, savings, stocks, bonds, other investments, retirement accounts, property, etc. All your savings accounts should be listed separately and added up together.
- Make a list of all your liabilities: This includes all your debts. Add up your mortgage, car loan, student loans, personal loans, medical debt, and any other debts you have. List them all out separately and come up with a total.
- Subtract your liabilities from your assets: List all your assets and then subtract your liabilities from them. The total you get is your net worth.
It’s also important to put the date on your net worth calculation because you should calculate your net worth annually. This allows you to see changes in your net worth over time, which can help motivate you to save more, spend less, and invest. Ideally, you’d sit down at the end of every year and calculate your net worth.
Mistake #4 – Following the crowd
In many cases, people only hear about an investment when it has already performed well – from a friend, coworker, or family member. If certain types of stocks double or triple in price, the mainstream media tends to cover that move and tell everyone about how “hot” the shares have been.
Unfortunately, by the time the media reports this story about shares rising, it’s usually after the stock has reached its peak. The investment is overvalued by this point, and the media coverage arrives late to the game. Regardless, the television, newspaper, internet, and radio coverage push the stocks even higher into excessively overvalued territory. We have seen this trend play out recently with the recreational marijuana stocks. Some of these tiny companies had only two or three employees, but that did not stop them from being valued at a corporate worth of about half a billion dollars!
Mistake #5 – Letting your emotions get the best of you
The bottom line is that stock markets have historically risen over the long-term. So, whenever someone tells me they want to sell their equity position, I always ask, “When do you need the money?”
If they can’t touch the money for many years due to penalties and tax ramifications, there essentially shouldn’t be a focus on the value of their accounts at this time. The only value that will ultimately matter is when you need to start taking distributions from the money in retirement.
Since 1988, the stock market’s average return has been 10% per year. But the average stock fund investor who does not have any kind of formal investment training has earned only 4.1% per year, according to Dalbar’s Quantitative Analysis of Investor Behavior. So, why are investors missing out on 60% of the market’s profits?
Because your brain gets in the way. Survival instincts have evolved into “behavior biases” that cause us to make bad financial and investment decisions, such as selling your equity position in a down market. When you sell investments at a price that’s lower than what you paid for them initially, you lose money. It’s that simple.
But if you ride out the storm, there’s a chance the market will come back up, and you’ll be made whole again on paper (or on screen). So, as tempting as it might be to liquidate your various holdings for fear that things will get even worse in the coming weeks or months (which they very well might), resist the urge unless you absolutely need money in the short to mid-term.
In March of 2020 and with the onset of the coronavirus pandemic, 42% of investors in a new survey sold at least one stock and 24% sold all their holdings, according to MagnifyMoney. As the stock market rebounded with record highs, 69% of investors who sold stock at the beginning of the pandemic said they greatly regretted their decision to sell.
Mistake #6 – Failing to diversify
Think of the New York City skyline for a moment. If I asked you what the chances were that all those shiny, tall buildings and the corporations that occupy the space would be out of business by next year, you’d probably say there was a very slight chance of that happening. However, if you concentrated on one of the buildings, let’s say the Empire State Building, and I asked you the same question, you would probably say that there is a much higher probability that the companies in that one building will be out of business next year.
When we pick individual stocks, we increase our risk dramatically. Not only do you have the everyday market risk, but you also have company risk.
The reason I believe you shouldn’t be a stock picker is simple: unless you are investing with money that you are literally never going to need in your life, the risk of individual stock investing is simply too high for us to recommend it, no matter how amazing the company seems.
Don’t take it just from me, but from Hendrick Bessembinder, a finance professor at Arizona State who studied how individuals’ stocks have performed compared to treasury bills. His study was called Do stocks outperform treasury bills?
The main takeaways from the study were:
- The best-performing 4% of listed stocks accounted for the entire lifetime dollar wealth creation of the U.S. stock market since 1926.
- Only 42.1% of all the stock returns were even positive; by definition, the one-month T-Bill rate was always positive.
- Less than half (specifically 47.7%) of one-month stock returns were greater than the T-Bill returns for the same month.
While the stock market created about $32 trillion in lifetime wealth over approximately ninety years, more than half of that came from only eighty-six top-performing stocks (out of nearly 26,000).
Think you can pick the future winners? (86 out of 26,000) Good luck!
So, why are the odds not in your favor?
First, you’re probably behind the curve of when you should invest in a company or sell shares. By the time you learn a piece of public information that you can act upon, it’s already been considered by large-scale investors. Thus, the market price has already been adjusted before you can react to it.
Let’s say a company issues great quarterly earnings, so it seems this is a steady company to invest in. By the time you as the individual investor are aware of this, the value of that company’s stock has already taken off.
On the other hand, let’s say some minor bad news comes out about a company and you want to sell because of it. By the time you can act on it, the company’s stock will have already fallen in value.
Large-scale investors (money managers) often hear such information before you do. Their computer systems react to such news instantaneously, and they have teams of people doing research for them daily. Therefore, you do not have a great chance of beating them.
Second, no one can’t predict the future. None of us have any way of knowing how long the economy may continue to rise or when we might see the next 2008. We don’t know if a company has a great product about to come out of R&D or if they are on the brink of collapse. We don’t know if some other company is going to come up with the next greatest product in a certain category and push your company aside, or if your company’s going to be the one to revolutionize it. And if you do, you are breaking insider trading rules.
Investing in a broadly diversified portfolio of multiple different stocks in different categories can help reduce these kinds of risks. By investing in large, mid-size, and small companies at once, you’re going to have some shares that take off like a rocket, some that somewhat idle in place, and some that drop.
The average stock market return in a broadly diversified portfolio is around 7%. This considers the high periods, such as the 1950s when returns were as large as 16%. It also takes into account the negative 3% returns in the 2000s. However, there have certainly been years during economic downturns where the average value has dropped.
On the other hand, individual stocks have years where they triple in value and years where they lose all value. As an individual, you have little ability to tell when either might occur.
In general, individual investors can’t really afford to lose their entire investment unless they’re already financially set for life and they’re investing with the excess. This is why diversifying your risk should always be a top priority.
If you want to be a stock picker, then you need a lot of time to do this well. To actually invest and not just gamble based on what you heard on CNBC or from your coworker, you have to spend time reading earnings reports and SEC filings. And I am here to tell you, I have seen people put in the necessary time and still lose much of their value because they never anticipated competitors entering the market.
If you decide you want to buy multiple individual stocks to lessen the risk of buying just one individual stock, then think how much research is going to be required to develop a true understanding of each company. You are essentially competing against money managers who have teams of people doing research on each company, who have way more resources at their disposal to compile information quickly, and who don’t have another day job.
One huge downfall of picking your own stocks is the emotional attachment you feel toward each company. I’ve found that many executives who have worked for one company for a long time have been rewarded very well with a matching 401(k), employee stock purchase plans, and a substantial income. Not to mention, you likely know a lot about your company, and you have emotional ties to your company. You probably believe in this company. Why else would you be investing your hard-earned money in them? This causes many employees, over time, to put more than 10% of their total financial portfolio in their company stock, which is the max you should have.
Yes, over-concentration in company stock could work to your benefit if the company does great. No one is saying Google or Facebook employees who received stock options got a bad deal, but holding onto too much of your equity compensation tends to cause a big problem when the company does poorly. (Hello, employees who lost everything because all their wealth was tied up in Citibank and Lucent in 2002.)
While concentration may CREATE wealth. Diversification will PRESERVE wealth. So where are you going to put the rest of your eggs? When creating a diversified portfolio, you create something we call the box approach.
Mistake #7 – Attempting to “time the market”
Instead of selling stocks and coming up with a new investment strategy, it is always prudent to stick with your original asset allocation and financial game plan.
It’s common for investors to want to sell their stocks and hold cash, but it’s impossible to determine when to get out of your equity position, and then when to get back into the market once you’re sitting on cash. If you miss the ten best days in the market, your return drops almost by half, from 9.85% to 6.10% (from $65,453 to $32,665).
This is the main problem with market timing; you never know when the best days of the market will be. Six of the ten best days occurred within two weeks of the ten worst days. So, for those who sold their position as the markets were dropping, there is a good chance they wouldn’t have put all their money back for the market upswing, which would have significantly hurt their overall return. This is why time in the market is more important than timing!
Mistake #8 – Only investing in passive index funds
The popularity of passive investing has grown quickly. Passive investment vehicles now account for over 45% of total fund assets versus roughly 10% at the turn of the century.
So, what are passive-investment vehicles? Simply put, they have predetermined fixed mandates, such as index funds or ETFs representing a sub-index, such as technology or healthcare. A passively managed index fund is a fund that is based on an index that doesn’t chase the latest trend. The managers make sure the underlying investments are always from the index it tracks.
The benefits of passive investment vehicles are lower fees, the ability to quickly gain diversified exposure to a sector, and ease of use. Lower fees have certainly attracted many people to passive investments, and the fact that there is little effort required to manage your own investments. Add to that the fact that 80% of actively managed mutual funds do not perform as well as broad market indices, and passive-investments vehicles would appear to be a logical choice.
But there are dangers as with anything else!
As most investors going into these types of funds do not have much investment knowledge, when markets go down, passive funds tend to go down further than active funds. Mainly because the active money manager can make decisions as the market begins to decline. They can go to cash, hedge, or invest more in bonds. However, the passive fund is stagnant and does not change its strategy.
With the notable exception of the financial crisis of 2008, most of the investors in passive funds have consistently had positive market returns generated by unusually low market volatility. Thus, the experience of most owners of passive-investment vehicles has been a steady march higher, with minimal volatility.
How will these investors respond to a sharp bear market, which is a decline in the stock market of 20% or greater? Investors with modest experience with market volatility and negative returns will be more apt to sell when there is psychological pain imposed by a significant bear market, and this creates greater danger for both the passive investor and markets in general.
Keep in mind as well that active money managers cost more than passive funds. This is because they are actively trading to try to beat the market. Because the money manager can sell to cash or hedge when the market is going down, they have a chance to create something called alpha, which is the excess return of an investment vehicle relative to the return of a benchmark index.
For example, let’s say the S&P 500 index earned 7%. If you own a large-cap blend active mutual fund, which is a basket of large-cap blend equities that created alpha, this means it would have earned a return of possibly 8%. Essentially, it beat the index by 1%. Over time, if you can find active management to consistently beat the market, this can make a difference in the long run.
Now, it’s hard to find active money managers who can do this, but for the possible added returns, it may be worth adding some active management into your portfolio.
Marissa Greco registered representative of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker/dealer (member SIPC). Investment advisory services offered through Lincoln Financial Advisors or Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. You may want to consult a legal or tax advisor regarding any legal or tax information as it relates to your personal circumstances.