We have all heard or read the story about the rabbit and turtle racing. As we know, the rabbit is faster than the turtle. The rabbit became so confident during the race that he stopped running and relaxed under a tree before finishing the race. The rabbit was so relaxed that he slept; the turtle passed the rabbit while he slept and finished the race first. The rabbit made the mistake of overlooking the turtle and not considering the possibility of a different outcome. For some investors, mistakes happen due to the investor only focusing on one circumstance and not considering other possibilities when investing.
In this blog, I will speak on some common mistakes investors make and how to recover from those mistakes.
Holding Too Much Cash: Although we probably use a plastic card or even an app on our phone to represent it, we use cash to pay our everyday expenses. Beyond the food, clothes, transportation, entertainment, and the mortgage that we budget for monthly, it’s a good idea to have an emergency fund of cash on hand to pay for unexpected car repairs, new furnaces, or medical bills. Depending on your expectation of income stability, that emergency fund could be anywhere from 3-6 months’ income coverage or even up to 8 months, depending on the circumstance.
But once you’ve got that secure, stashing more in cash is a bad idea. There is a common misperception that cash is safe in protecting your principal. If I have $50,000 in the bank today and don’t spend it, I’ll have $50,000 next year and $50,000 twenty years from now. The problem is just that. While I will have the same amount of money in nominal terms, my twenty-years-from-now $50,000 will not buy the same thing that my $50,000 will buy today due to the erosive power of inflation. In fact, at just 2%-per-year average inflation, my future $50,000 will only buy the equivalent of less than $34,000 of goods and services. Inflation will erode your purchasing power if you leave a significant portion of your retirement funds in cash or cash equivalents like marginal-return bank CDs.
Some people hold on to too much cash because they fear the market. Some people have analysis paralysis and are always looking and waiting for the non-existent perfect investment. Either way, by holding cash, you are losing money.
Failing To Considered Fees: If some people overthink the kind of investment to make, many people underthink the question of fees. There is a whole debate about actively managed versus passively managed mutual funds. Active funds pay one or (usually) more fund managers to determine their fund’s mandate, conduct research, and buy and sell stocks according to which they expect to perform best within that mandate. The debate hinges on two questions:
Do active managers choose better stocks for their funds, causing the funds to generate higher returns?
Do the higher fees that result from paying the managers and making more transactions effectively obliterate the higher returns?
The answers are inconsistent from year to year or across different fund comparisons. However, historical performance demonstrates that active management only generates excess returns—that is, returns beyond what a comparative index generates--in SOME years. Despite this, you are still assessed the higher fees EVERY year as an investor. So, the probability of getting higher returns from your active investments varies yearly, but the likelihood of paying higher fees on those investments is 100% every year. I’ll let you draw your conclusions.
In addition to the cost of paying the managers, there are the transaction costs for buying and selling the stocks. Passive funds are designed to mirror an index and purchase the same stocks that comprise the index in the same proportions. No one is paid to research or make decisions, and since index composition changes rarely, transaction costs are low.
Admittedly, reading a mutual fund prospectus can be less efficiently enlightening than reading your auto manual. Still, Morningstar and other reporting services happily put fees and other information on the Internet. Or, you can ask your financial professional for a one-pager on each fund.
You must also consider management fees if someone else manages or advises your money. Money management is a service, and you should pay something for it since it frees up your time to get paid to do something else. But make sure you are getting something in return for the fee. Compare rates and services. Do not confuse investment or money management with financial planning. Investment management is selecting a portfolio of investments suitable for you and advising you when to buy or sell parts of that portfolio, mainly based on external circumstances.
Financial planning is a more comprehensive process of defining multiple and often interdependent financial goals and developing, implementing, and monitoring strategies to reach them according to your external circumstances. Ensure you know which one you are paying for and which you are getting.
The question comes down to transaction costs for those who invest in individual stocks and bonds. Go with a low-cost brokerage. However, competing companies have no trade cost for individual stocks these days.
Timing The Market: Regardless of whether your advisor is a money manager or a financial planner, and regardless of the nature of that person’s compensation, one of your advisor’s tasks should prevent you from trying to time the market. I say “trying” because no one can do it. Timing the market means buying before it rises and selling right before it declines.
There is a myriad of factors that cause market movement. Some are rational; some are not. Some can be analyzed to a certain extent, and some cannot. However, NONE can be predicted with enough frequency for market timing to succeed more than it fails. In addition to the likelihood that you will “miss the window” to time the market, attempting to do it will generate unnecessary transaction costs. Particularly with the growing volume of robo-trading engineered by super-computes, the market frequently moves too fast. Once you notice the direction, it’s often too late to benefit from following it.
Over the long run, the stock market will go up. In the short run, it will have varying degrees of up-and-down volatility. As tired as it seems, buy-and-hold is the most efficient way to go. Periodic rebalancing will keep your portfolio mix in suitable proportion, but the rebalancing should occur according to pre-set considerations rather than the market’s bull or bear sentiment.
Ignoring Liquidity: Probably every financial professional has had a client that either comes with investments that are not commonly traded securities (stocks and bonds or mutual/index/exchange-traded funds comprising stocks and bonds) or expresses a strong interest in them. Such investments include everything from real estate, energy sources, livestock and commodities, crypto-currencies (such as Bitcoin), antiques, collectibles, and art.
Unless you or your advisor happens to have professional experience in the relevant industry, it can be challenging to accurately assess these investments in terms of risk versus reward—in other words, are the possible returns you might get on this investment a good trade-off for what you could lose from this investment? One criterion, though, is straightforward to investigate and should play an enormous part in the decision to purchase any investment. That is Liquidity.
Suppose you have two children. You don’t like or trust the stock market but are fond of real estate. So, you purchase two investment properties. You plan to sell the properties as each of your children approaches college age and use them to fund their higher education. The potential pitfall to this strategy is not just that the local real estate market might take a downturn. The same thing could happen with the stock market. But in a downturn, real estate can be much more challenging to sell than securities. Even in a good market, selling a highly desirable property after inspections and showings can take months. And although you can liquidate a security portfolio gradually, giving the market at least some chance to recover, you generally cannot sell just part of a building.
Many of us have had the experience of purchasing collectibles—coins, figurines, stamps, baseball or Pokémon cards, porcelain dolls, vintage toys, or Beanie Babies®, to name a few—with the expectation that the price will rise and that there will always be a ready market, only to find the popularity of and interest in the item dropping off a cliff and prospective buyers vanishing into thin air. An investment is only valuable if someone is willing to buy it from you for the cash you need to pay for your children’s education, retirement, or long-term care. EBay and Amazon can significantly broaden your potential customer base, but even these sites cannot create a market and liquidity for something no one wants anymore.
Failing To Understand The Product: Annuities are a lot like specific sports teams or politicians in that many people either love or hate them with either emotion taken to the extreme, so I’m using this as my product example. There probably are some terrible annuities out there. But for the most part, annuities are not intrinsically good or bad. What they ARE is misunderstood. Annuities are investments wrapped in insurance. To the best of its corporate ability, an insurance company guarantees you, the annuity owner, some aspect of your investment; for example, how much it will earn, how long it will last, or the maximum it can decline. Your homeowners, auto, health, and life insurance are not free. So, this insurance is not on your investment. Annuities do certain things that other investments don’t or can’t.
If you want to ensure your money lasts as long as you do, an annuity can do that. If you like to ensure that your principal will stay intact or that your heirs will get a certain amount of money, an annuity can do that. If you want to find a way to defer taxes after you’ve maxed out your retirement plans, an annuity can do that, too. However, there is a charge for each of these features. And generally, there’s a charge for not holding the annuity for a certain minimum period. Annuities are not truly liquidity-challenged, as discussed above. You can get your money out anytime but may pay a hefty charge.
Annuities, permanent life insurance, financial derivatives (options, swaps, collateralized debt, and the like), and Master Limited Partnerships (MLPs) are just some of the more complicated investments available. Each of them serves a kind of need, and sometimes, the need is the kind you have.
To avoid mistakes, you need to be sure:
Whether you need or can benefit from what the investment does.
How much will it cost to meet that need or obtain that benefit?
The Take Away
Investing overall comes with many twists and turns. You go through good, profitable times and not-so-good times. Inevitably, mistakes might be made, but there is always an opportunity to learn from your mistakes and complete the necessary changes to help you achieve your goals. Mistakes are the seeds from which trees of knowledge grow.
This work is powered by PreciseFP and may be a derivative of the original.
The information herein is intended for educational purposes only and is not exhaustive. Diversification or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your situation.
FINRA has not reviewed this content.