Investing money is generally undertaken with the purpose of achieving specific goals. These goals may include saving for college, retirement, or buying a house. But investing mistakes can sabotage these goals.
Certain factors may be out of your hands when you invest. An example would be the investment return for a specific asset class over a specified time period. But there are several things you can control.
There are many mistakes that investors make which you may be able to avoid. All you need is some common sense, and a bit of careful analysis and planning. Avoiding these mistakes will help you stay on the right track and increase your chances of meeting your goals.
You’ve no doubt heard the expression don’t put all your eggs in one basket. Well, this is sound advice when it comes to investing. Even the best analysts on Wall Street cannot predict with certainty what any investment will do in the future. This is why you have to spread your investment dollars among different categories of investments.
You must diversify among asset classes and within asset classes. Examples of asset classes are stocks, bonds, cash, commodities, etc.
When diversifying within the equity (stock) asset class, for example, you can diversify among industries and sectors, as well as geographically. Not to mention that you can also diversify based on company size (small-cap vs large-cap), and investment style (growth vs value).
Another example is diversification within the fixed income (bonds) asset class. There are different types of bonds such as treasury, municipal, corporate, etc. Each can have a different maturity, credit rating, yield, etc.
Investment vehicles such as mutual funds and ETFs can allow even beginner investors with small portfolios to diversify efficiently and easily. After your portfolio reaches a certain size, you can even diversify using individual stocks and bonds.
You should also diversify among advisors or brokers if you have substantial investable assets. We have unfortunately seen plenty of examples in recent years of what a potential rogue advisor can do to the life savings of investors.
Especially in the current low interest rate environment, higher yields are in demand. Sometimes you see a juicy dividend or interest yield and you may get excited. You may think you’ve stumbled upon a great investment opportunity. But a high yield can be an ominous sign. For example, a stock or bond with an abnormally high yield can be a trap.
Abnormally High Dividend Yields
The dividend yield is computed by dividing the annual dividends paid per share by the stock price. Sometimes a company is going through some tough times and the stock price falls substantially. This makes the dividend yield look really attractive. But if the company’s struggles continue and earnings decline, the dividend payment may be reduced or cut completely. This is done in order to save some money and get the company’s finances back on track.
Also, sometimes the dividend yield you see on the internet may be the trailing twelve months yield. Oftentimes, the company may have already cut or suspended the dividend and you may not be aware of it. So some research is often necessary to uncover the current state of the company’s dividend. Look for any guidance management may have provided with regard to the dividend payout.
The same can be said for a group of stocks such as those in a particular sector or industry. For example, many banks’ dividend yields looked temporarily attractive during the early part of the 2008-2009 financial crisis when prices plummeted. But many of those dividends were shortly thereafter cut or suspended due to the earnings declines.
Another example is the dividend cuts brought about by the struggling stock prices and earnings of companies in the energy sector in recent years.
Abnormally High Bond Yields
The principles above apply to bonds as well. A bond’s current yield is computed by dividing its annual coupon payments by its current price.
A company which is in financial trouble, for example, will have bonds which trade at a relatively high yield. The reason this is so is that expectations for a full recovery and principal payment are very low. So the bond price has dropped to reflect this. Even a low coupon bond can have a high yield if the price drops low enough.
Trying To Time the Market
As indicated above, no one can predict with consistency and certainty how specific investments, and the financial markets as a whole, will perform over any specific time frame. As such, it is futile to try and time exactly when you should invest your savings.
Now granted, there may be conditions where you believe the market is overheated or ripe for investing. For example, it may be trading at the high end of its annual or multi year range. Or you may be looking at a stock market, for example, that has just dropped substantially in value and is trading at the low end of various short and/or long-term ranges.
But a hot market can stay hot for several years (as we’ve seen since the 2008-2009 financial crisis). And a stock market can remain in a slump for several years as well (as was the case after the crash of 1929 and during the Great Depression).
It Doesn’t Have To Be All or Nothing
Waiting on the sidelines for several years trying to predict a top or a bottom will be very frustrating. It is a very difficult feat to accomplish with any accuracy or consistency. At the same time, you don’t have to go all in when the markets are hot. A better bet is to continuously invest a portion of your income on a regular basis. Alternatively, you can also choose to invest a bit less when the market is hot, and a little more when it has pulled back.
For example, you may choose to invest 10% of your monthly income on an ongoing basis. If the market is at or near it’s 52 week highs in a particular month, you may choose to invest only 5% of your income during that month. Alternatively, if the market is closer to it’s 52 week lows during a particular month, you may choose to invest 15% of that month’s income.
If you are an active investor, you may also be able to find investments trading at bargain prices in any type of market. With some research, it is possible to uncover opportunity in certain asset classes, industries, sectors, or individual securities. Value is harder to find in hot markets. But even then, some bargains can usually be found every now and then.
Paying Too Much in Fees
You must be cognizant regarding the fees you are paying with relation to your investments. Some of these fees are easier to see, but others are more stealth in nature.
Money you pay to an advisor for investment management is typically debited from your brokerage account on a quarterly basis. So a quick look at your monthly statement will alert you to any such fees.
However, you may also pay a commission when you buy or sell a stock, ETF, or mutual fund. Such charges reduce the amount invested when you buy, and the sales proceeds when you sell. So you have to pay a little more attention to these types of expenses so that you can determine exactly how much you are paying.
Besides advisor fees and commissions, you also have internal fund expenses for investments such as Exchange Traded Funds (ETFs) and mutual funds. These fees are referred to as the fund’s expense ratio. The expense ratio can be found in the fund’s prospectus, or online on websites such as Morningstar.
Passively traded index funds typically have lower expense ratios than actively traded ones. This does not mean that you should avoid actively traded funds at all costs. Just be aware of what you are paying and see if it makes sense.
Whether it’s a broker’s or mutual fund’s commission charges, an advisor’s fees, or a fund’s expense ratio, you should comparison shop and aim to keep costs down.
Bid / Ask Spreads
Finally, be aware of the bid/ask spread of an investment. Quotes for securities such as individual stocks, bonds, and ETFs typically contain two prices. The lower one is the bid, and the higher one is the ask. You can sell at the bid, and buy at the ask. The difference between the bid and the ask prices is the spread. Mutual funds are only priced once at the end of the day, so there is only one price and no bid/ask spread.
The higher the spread, the more you are paying. The reason being that given a bid/ask quote, you buy at the ask. If you were to instantaneously turn around and sell that same investment, you would only be able to sell it at the lower bid price. The difference is the market maker’s markup (profit).
Stocks and bonds that lack liquidity due to low volume and/or infrequent trading generally have higher bid/ask spreads. Like any other fees, high bid/ask spreads can eat into your returns.
Not Minimizing Taxes
Taxes can also eat away at your returns and your net worth if you are not careful. For starters, you must be aware that there is a difference between tax deferred accounts and taxable accounts. Tax deferred accounts include IRAs, 401Ks, and other pension or retirement accounts. Taxable accounts are just regular accounts you open with a financial institution such as a broker or mutual fund company.
Be Aware Of Where You Place Your Investments
It is important to realize that certain types of assets are more tax efficient in certain accounts. For example, taxable income producing assets are better off in tax deferred accounts. This includes assets such as high dividend paying stocks or funds, and interest paying treasury and corporate bonds.
Income generated within tax deferred accounts can accumulate and avoid taxation until it is withdrawn, typically many years later during retirement. Some relatively newer types of accounts such as Roth IRAs and Roth 401ks allow you to avoid taxation. Even after you withdraw the money at retirement. However, the trade-off with these accounts is that you do not get an up-front tax break for the contribution into the plan as you do with traditional IRAs and 401ks.
Any regular and consistent trading that will generate capital gains is also better done inside a deferred account.
There are also assets which may make more sense in taxable accounts. This includes low or no dividend paying stocks or funds, discount bonds, and tax-free municipal bonds. The low income and/or tax free income generated by such assets should have a relatively small impact on your taxes, if any.
Potential Tax Ramifications Should Not Determine Your Investment Selection
Sometimes it’s not practical or possible to strictly allocate all your investable assets exactly this way along taxable and tax deferred accounts. For example, you may just happen to have much more money in your taxable accounts, and not so much in your retirement accounts. This does not mean that you should avoid high dividend or interest paying investments just to minimize taxes.
The quality of the investment should take priority, and the minimization of taxes should be a secondary factor. Besides, you may be in a low tax bracket where any tax generated by investment income can be minimal.
Keep Track of Your Holding Period
When it comes time to sell, you should also be aware of how long you have held an investment. There is a significant difference between the tax rate on short term capital gains and the rate on long term capital gains.
So, for example, you may be about to sell an investment which you’ve held for just under one year. This sale is expected to result in a significant capital gain. It may pay to hold for another few days or weeks to change the capital gain treatment and save some taxes.
However, again, the potential tax consequences should not be the sole determinant of your investment decisions and actions. For example, you may need the sales proceeds for a specific purpose. If the net-after tax proceeds at the current price will suffice to meet this need, then you may be better off selling immediately.
Waiting days or weeks just to get long term capital gain treatment may risk allowing the investment to drop in value significantly. If such a fall exceeds any tax benefit, you may not be able to meet your specific need.
Shorting Stocks or Other Investments
When you buy a stock or other investment hoping the price will go up, you are said to go “long” the security. Shorting, on the other hand, is when you borrow a stock or ETF and sell it without owning it. When you go “short”, you are hoping the investment’s price goes down, so that you can buy it back for less than what you sold it for, and return it to the lender.
The borrowing and returning of the stock is all done by the broker behind the scenes when you sell and then buy back the stock. When you place an order, you generally have the option of going “long” or going “short” a particular investment. However, keep in mind that sometimes an investment is not available to be borrowed, and therefore cannot be shorted. Also note that certain investment types such as mutual fund shares cannot be shorted.
Why is “Going Short” Risky?
Shorting is very risky for two main reasons. First is the unlimited loss potential. When you buy or go long a stock, for example, the most you can lose is 100% of your investment. However, when you go short a stock, it can rise more than 100%. So your loss is theoretically unlimited.
An unforeseen event such as a merger or acquisition at a large premium, or the announcement of a breakthrough product, can cause a very quick loss. This will happen if the price shoots up and you are short the investment. Similarly, a hot market can cause a gradual significant increase in asset prices as well.
The other main reason shorting is risky is that the demand for the stock may increase. As such, the broker may need to return the borrowed shares. If the broker cannot otherwise replace the shares you are short, your position will be liquidated. This means that your position will be closed out without much warning at the market price, and potentially at a significant capital loss.
Borrowing Against Your Investments (Margin)
When you are said to “use margin” or to “margin your account,” you are essentially borrowing against your investments. You can borrow money to purchase more investments. Or you can use it for some other purpose such as a down payment on a home. But utilizing margin is very risky and should be avoided.
You may be able to borrow up to specified amounts of the equity in your account. But the problem arises from the nature of stocks and financial market investments. If the value of the investments on which you borrowed money falls below a certain threshold, you may receive a “margin call” from your broker. This means that you must deposit additional funds into your account to get past the required equity threshold.
If you do not do this, then your broker will likely liquidate investments in order to meet this requirement. This can result in selling at an inopportune time, when the investments have fallen in value. Significant capital losses are common when this happens.
Trading Options and Futures Contracts
An in-depth discussion on the ins-and outs of options and futures contracts is beyond the scope of this article. However, suffice it to say that non-professional investors should not get involved in these types of investments.
These are derivative types of securities. This means that their value is derived from the price of another underlying investment such as a stock or index.
Options contracts have expiration dates, and the majority of options contracts expire worthless. Not to mention that many options contracts are volatile and/or not heavily traded. They therefore can have very high bid/ask spreads.
Futures contracts, on the other hand, are typically used to trade the value of commodities such as oil, gold, or grains. But there are also futures contracts for other assets such as currencies, and indexes such as the S&P 500 and the Russell 2000.
Futures contracts are highly leveraged instruments. This means that a very small move in the underlying index or commodity price can cause a large percentage move in the futures contract’s price. As such, large gains or losses can occur very quickly.
Derivatives are Better Suited for Professionals
These investments are better left to the professionals. They have more training, knowledge, and experience in trading these instruments. Not to mention risk management tools and the backing of major financial institutions.
However, even professionals can get into trouble with such risky investments from time to time. On the professional level, they are often used as risk hedges or to mimic an index (such as when creating an ETF).
Using such instruments as a means to purely speculate on the direction of the underlying asset’s price is generally not a good idea. Quick and significant capital losses can wipe out your account in no time.
A Small Difference In Net Investment Return Can Be Very Costly
You may think to yourself that a one percentage difference in net investment return is not very significant. A one percent or higher reduction in your returns can result from tax inefficiencies, high fees, etc. But let’s take a look at how such a small difference can have a large impact on your net worth over time.
Let’s say you invest a lump sum of $100,000 for a period of 25 years, at an annually compounded rate of 9%. At the end of this time period, your investment will have grown to $862,308.
However, if that rate of return is reduced just a “little” to 8%, the portfolio will be worth only $684,848 at the end of the time frame indicated. So a small change in net annual investment return can result in a big difference in portfolio value over time.
You should do everything reasonably possible to maximize your chances of meeting your financial goals. Part of this process involves avoiding common mistakes that investors often make.
Doing so will help you to minimize any setbacks that can put a dent in your portfolio and hamper your chances of investing success.