Learn what to avoid so you can maximize your investments
Posted by: Team Tony
What’s the biggest thing successful people have in common? They are obsessed with not losing money. How do they do it? One big way is by investing smart. They don’t necessarily take big risks. They learn from their mistakes and avoid making stock investing mistakes and other common errors.
Investing mistake 1: Wrong asset allocation
Anybody can become wealthy; asset allocation is how you stay wealthy.
Asset allocation means dividing up your money among different investment classes (stocks, bonds, commodities, real estate, etc.) according to your goals, needs, risk tolerance, and stage of life – and it’s your most crucial investment decision. Asset allocation protects you from a lack of diversification, from falling in love with one type of investment and not owning various types of assets.
However, asset allocation is more than just diversification. You can be diversified across asset classes or investment types (although not diversifying is also a common stock investing mistake), but are you also diversified across risk?
Many investors know about and understand asset allocation but still make the common investing mistake of not putting it into practical use. Let’s walk through what it really means for you.
Think of your assets as your favorite sports team. The best teams have an aggressive offense and a strong defense, and the coach knows the strengths and weaknesses of each. You want to set up a specific proportion of your portfolio as your tail end or defensive position – we call this your Security or Peace of Mind bucket, into which you allocate lower-risk assets designed to protect you if your offensive players take a hit.
You will then set aside a specific portion of your money as your offensive strategy or risk/growth bucket. Although it will likely be the wealth-growing portion of your portfolio, it is also the riskiest and most volatile.
Finally, you have a Dream bucket for the enjoyable things you want. The dream vacations, the outrageous gifts — you fill in the blanks. This bucket isn’t for financial payoffs; it’s designed to enhance your overall quality of life and inspire you to realize your dreams.
Poor asset allocation is one of the most common mistakes in investing, so it’s wise to seek help building that portfolio and filling those buckets. Take advantage of a free evaluation of the health of your asset allocation and see how you compare to professionally designed portfolios. And when you do seek help, be sure not to make mistake number two.
Investing mistake 2: Using a broker instead of a fiduciary
During his time in the White House, President Obama urged the Department of Labor to update their regulations of the financial industry and implement a fiduciary standard. Why did the executive office take a close interest in broker regulations? Because brokers – also known as registered representatives, financial advisors, wealth advisors, and more – were held to a “suitability standard” which did not require them to have their client’s best interests in mind.
Brokers often work for large, name-brand firms whose sole goal is profit. So, the person you turn to, although kind and trustworthy, works in a closed-circuit environment where the house always has the advantage. Conversely, a fiduciary is independent and free of conflicts (or, at a minimum, they must disclose). A trustworthy fiduciary advisor never receives commissions to sell you a specific investment, or what you might call “having a dog in the fight.”
So what does it cost you to receive conflicted advice?
Using a broker instead of a fiduciary is one of the biggest stock investing mistakes. According to The President’s Council of Economic Advisors, it costs Americans one percent of their return annually. One percentage point doesn’t sound like much, but that can reduce your savings by more than a quarter over 35 years.
Instead of a $10,000 retirement investment growing to more than $38,000 over those 35 years (after adjusting for inflation), you’d only receive $27,500
Investing mistake 3: Overlooking your taxes
Did you know that the average American will pay more than half of their income to interest expenses and taxes (income tax, property tax, sales tax, tax at the pump, etc.) throughout their lives?
Insiders know that it’s not what you earn that matters; it’s what you keep. Tax efficiency is one of the most direct pathways to shorten the time it takes to get from where you are now to where you want to be financially. So why is investing without taxes in mind such a common investing mistake?
Tax-loss harvesting is one big way you can improve your tax efficiency. Offsetting your capital gains with your capital losses can lower your overall tax bill – meaning you get to keep more of your money. Let’s say you have an underperforming fund with a $5,000 unrealized loss for the year and another with a realized gain of $20,000. Instead of being taxed on the entire $20,000, you can sell the $5,000 fund, deduct it and pay taxes on only $15,000 instead.
Ignoring taxes seriously impacts your ability to create compounded growth for your future life. There is no good reason to pay more taxes than you have to, and every reason to avoid unnecessary taxes. Tax efficiency = faster financial freedom. Talk to your registered investment advisor and your CPA and utilize resources such as MONEY: MASTER THE GAME and this blog to discover 100% legal strategies for maximum tax efficiency.
Investing mistake 4: Overpaying for high-cost mutual funds
Mutual funds pool money to invest in stocks, bonds, and other securities. Many people who want to avoid stock investing mistakes believe mutual funds are safer ways to invest in securities because, for years, the media sold the lie that mutual funds are the most effective way to grow our 401(k)s. Unfortunately, it’s just not true.
The truth is that 96% of actively managed mutual funds do not beat the market over 15 years. Active managers try to beat the market with great stock picks, but the 4% that achieves that constantly changes. Betting on a jockey who won the last race does not mean he will win again, and chasing performance is a fool’s errand.
How badly does this actually hurt us? Over a 20-year period – December 31, 1993, through December 31, 2013 – the S&P 500 returned an average annual return of 9.28%. However, the average mutual fund investor made just over 2.54%, according to Dalbar, one of the leading industry research firms. That’s nearly an 80% difference!
To add insult to injury, according to Forbes, the “all-in” cost of mutual funds averages 3.17% per year when you add the management fees, the transaction costs, the sales loads, etc. This number doesn’t sound high, but consider this: the market remained flat between 2000 and 2009, a period known as the lost decade. There were lots of ups and downs, but nobody made money. During this flat period, hidden fees of 3% annually would decrease your portfolio from $100,000 to $70,000 (a 30% decline).
You put up the capital, took all the risk, and committed one of the most common investing mistakes. Your mutual fund firm made all the money.
Investing mistake 5: Failing to rebalance
Occasionally, a part of one of your buckets will grow significantly and disproportionately to the rest of your portfolio and throw you out of balance. If you don’t rebalance your portfolio regularly, you’re making one of the most common investing mistakes. Rebalancing means looking at your buckets and ensuring your asset allocations are still in the correct ratio.
Let’s say, for example, you start with 60% of your money in your Risk/Growth bucket and 40% in your Security bucket. Six months later, you check your account balances and discover that your Risk/Growth investments are taking off and no longer represent 60% of your total assets – more like 75%. That means only 25% of your money is safely in your Security bucket. At this point, it’s time to rebalance.
An experienced fiduciary can help you avoid the huge stock investing mistake of not rebalancing your Risk/Growth bucket — where you invest in equities (stocks), high-yield bonds, real estate, and other higher-risk assets. The prices of these assets constantly change, so this bucket will need rebalancing when you look at your overall asset allocation.
The challenge with rebalancing is the mental discipline required to get it done. When a portion of your portfolio is doing well, it’s easy to convince yourself that your investment successes will continue forever or that the market can only go up. This thought process causes people to stay with an investment too long and lose all their gains (a prevalent stock investing mistake). The rules of rebalancing don’t guarantee you’ll win every time. But rebalancing increases your chances of winning more often.
How often do you need to rebalance? Most investors rebalance once or twice a year. Some rebalance more frequently, choosing to watch their portfolio more closely and adjusting when it starts to shift. Rebalancing too frequently can hurt as you’re not “letting your runners run.” The number of times you rebalance does impact your taxes, however. When your investments are not in a tax-deferred environment, and you rebalance an asset owned for less than a year, you’ll typically pay ordinary income taxes instead of the lower long-term investment tax rate.
Avoiding common investing mistakes is a matter of having the right knowledge and the ability to put it into practice. Successful investing is also about developing a growth mindset. Once you commit to constant and never-ending improvement, your investments will also likely improve.
