Financial advisers often say that risk is the source of increased reward for investors. While taking some risk to achieve a certain measure of returns is necessary, this can often be misdirected into making familiar investment mistakes-most of which could be avoided if you were aware of them upfront.
Here, then, are the 7 Deadly Sins of Investing; mistakes to which both new and experienced investors can fall prey. See if you recognize these bad choices in your own investing habits, and try to avoid them when it comes to future investment decisions.
1. Too much of a good thing (concentration risk): Is your portfolio heavy with relatively new tech stocks, or one high-flying company that seems to defy gravity? Even if that one company has outperformed for a decade or more, it only takes one bad quarter and you're potentially sunk. Perhaps it's a bad management decision, or new regulation, or possibly an unforeseen shortage of raw materials that diminishes capacity. The truth is there's a myriad of risks in every business. Don't put all your eggs in one basket. Diversification is the key to building a successful long-term portfolio.
2. Bandwagon buying (following the crowd): Some financial television personalities these days love real estate investment trusts. A few years ago they couldn't buy oil companies fast enough. Before that, it was mall retailers. Get the picture? By the time it's TV fodder, you probably missed the trade. Generally, don't attempt to time markets. The odds are not in your favor. If you're investing for the long haul, it's important to ignore the daily roller coaster of market movements and let asset allocation, rebalancing and predictable compounding build your wealth instead. Chasing returns usually ends in tears.
3. Speed dating (short holding periods add costs and risk): Stocks are volatile and chasing profits over extremely short time frames is a risky business. Buying and selling stocks over hours, days, even a few weeks … that's straight-up casino thinking. Transaction fees alone (the house) will eat your gains-assuming you have any. The message is clear: stay away from day trading. The alternative? Give yourself better odds and less risk of losing hard earned cash by diversifying, investing over the long term and continually rebalancing. It may sound boring when compared to spinning a roulette wheel, but is more likely to help you reach your financial goals.
4. Trading in the unknown (complexity): Let's say your broker says "See, we trade these futures and then make a swap against a pan-European CDS on the open market, then reverse auction them to Asian central bank buyers…" Got that? More than likely, he doesn't understand it, either. Time to run away. This lesson is simple: If you understand how the company makes money and how you earn appreciation, income, or both, you understand the investment. If you don't, be very, very cautious.
5. Paying high fees (unnecessary costs): Avoid paying high fund fees-there is really no reason you have to. There are multiple high-quality funds that don't charge any upfront load fees and have expense ratios well under 1%. Studies have shown that low fees and expenses are an excellent predictor of success. Time and time again, low-cost funds have been shown to beat high-cost funds. A single percentage point can cost you thousands of dollars over 20 years. Bottom line: Look closely at the fees attached to your funds. Consider replacing costly funds with cheaper alternatives. You won't be sorry in the long run.
6. Forgetting the tax man: Maximize your investment returns by taking simple but smart steps when it comes to tax. For example, you're better off holding REITs (real estate investment trusts) in a tax advantaged account, given they distribute 90% of their income annually. Avoid short-term capital gains by generally holding investments for at least a year. Better yet, use dividend cash to buy and rebalance, selling nothing. No selling, no taxes. No taxes, more cash to compound.
7. Inflation? What inflation? (confusing nominal and real return): You made 10 percent trading stocks in the markets. Congratulations. But how much will that buy you down the road? A study by Thornburg Investment Management looked at $100 invested in the S&P 500 from the end of 1980 through 2010. It found that a nominal 10.71 percent return after fund expenses and taxes (dividends and capital-gains) came to 8.56 percent. Not too bad, but the real return (your return after allowing for inflation) was only 5.23 percent. When making long term investment decisions, don't forget to factor in inflation.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.