People in the United States have done a pretty good “about-face” in the past couple of years. Saving has increased and spending has been curtailed somewhat in the face of the uncertain economy. Saving more and spending less is great; however, when it comes to investing, there are a few common mistakes people make time and again.
A common theme for investors is to hold onto a losing position (hoping it will bounce back.) In fact, this loss aversion can even be magnified and cause some investors to sell all their holdings during market turmoil. We saw it happen a lot in the very recent past. To address this, create diversification. Own a decent number of stocks and view that “loser” as just a small piece of the portfolio. Next, be objective. If the “loser” doesn’t look like it’s going anywhere, don’t be afraid to get rid of it. Other holdings in your portfolio should make up the difference over time. Finally, when addressing the issue of selling all your holdings during market turmoil, the answer is to put your “head in the sand” because it’s been proven time and again that timing the market doesn’t work in the long run.
Two major investor mistakes go hand in hand. First, the investing public tends to pour money into mutual funds that post strong performance numbers. Unfortunately, evidence shows that, most of the time, after a mutual fund has a good year, there tends to be a “reversion to the mean,” meaning that the fund drifts from great performance to underperformance. This can be a vicious cycle, because the investor might go into the fund after the good year and then sell as it drops in performance. The goal is to buy low and sell high as opposed to doing just the opposite.
Hand in hand with chasing mutual fund returns is the fact that investors fail to understand the odds against beating the market. This is the argument of an actively managed (stock-picking) approach versus a passive (own-the-entire-market) approach. Evidence again shows that high transaction and management expenses, faulty psychology and the law of averages often weigh down actively managed portfolios. Quite simply, it’s hard to beat the market.
Ignoring the costs of mutual funds and other investment products can also be a setback. These costs take away from your returns. One study shows that during a 15-year time period, a low cost fund eats up less than 7 percent of your returns, while a high expense fund can devour almost 20 percent.
Investors also can become paralyzed because of too many investment choices. And there are people who just can’t bring themselves to move out of the “safe” environment (even partially) into something more long-term growth oriented (as in the record amount of cash still sitting on the sidelines today). To address this paralysis, think about how you need your portfolio to grow to support retirement, and then pinpoint the right mixture of equities to fixed income. There are various ways to do this (ie. age-based, income needs, size of portfolio). On the equity (stock) side of the picture, Savant starts with a well diversified portfolio that covers all the different market capitalizations, includes domestic and foreign holdings, and even some alternative investments.
This is the basic model almost all investment providers use. The next step, however, is to take a systematic approach to address the issues we’ve talked about above (passive vs. active management, cost, chasing returns).
Over the course of a long-term investment horizon, addressing these core issues can really make a difference in the “numbers” you see down the road. ❚
Brian Conroy is a financial advisor at Savant Capital Management, a fee-only wealth management firm in Geneva, Ill. Savant is a Registered Investment Advisor.