We see some of the same mistakes repeated over and over again by ordinary investors…
Mistake No. 1:
Looking For a ‘Magic Bullet’
Many investors look for the “best” mutual fund thinking that there must be a handful of funds that can bring the desired return. In fact, each mutual fund focuses on very specific types of investments, such as large company stocks, small company stocks, government bonds, etc. In any given year, any one of these market sectors could do well or poorly. Investors may want to use a mix of different types of funds. This is called asset allocation. Many mistakenly believe that asset allocation is designed to provide greater returns. That’s simply not true. Its goal is to reduce volatility risk. Smoothing things out can make it easier for investors to ride out market turbulence, and avoid major portfolio losses.
Mistake No. 2:
Getting out After Markets Drop
Market declines are inevitable. However, despite all advice about “staying the course,” many investors sell out of their stock position during market declines, often after the decline has bottomed out. Somehow they believe that they can sit on the sidelines until the markets go back up again and then jump in. The problem is that we become aware of market declines and market surges only after they have happened – when it’s too late to do anything. Following the market decline of 2008, investors sitting on the sidelines from March through December of 2009 missed one of the largest market rallies in history. Although there are strategies and indications when markets are overheated, it’s tough for most individual investors to know when to get out and just as tough to know when to get back in.
Mistake No. 3:
Stopping Contributions When Markets are Dropping
For the long-term investor, there really is no better time to be adding money to investment accounts than when they are down in value. Although we know that past performance can’t guarantee future results, long-term investors have the potential to benefit by continuing to purchase during market declines, reaping rewards later if the values return. This works best when the investor is using mutual funds or other broad collections of securities.
Mistake No. 4:
Confusing Stock Market Value with the Economy
The economy is the sum total of all the economic activity in the country: jobs, business profits, debt, consumer spending, and lots of other factors. The stock market represents the perceived value of stocks of individual companies. Companies can make money during recessions. And great economies can lead to poor stock market returns. Profits affect the perceived value of a company, and so stocks can rise during recessions. Just because the economy is slow to recover, that doesn’t mean the stock market will be. The 1990’s were a great period for the stock market, but what we found that much of it was based on speculation and wildly over-inflated stock prices. Investors have to realize that the stock market and the economy can be two entirely different things.
Mistake No. 5:
Paying too much attention to the media
The almost constant onslaught of news about the markets and the economy can cause investors to focus on short-term data that really doesn’t have anything to do with their long-term performance. There is always some crisis somewhere that affects the markets, but in the long run, the markets will for the most part reflect business profits of companies. Just make a list of all the worries and predictions made by the talking heads over the course of a week, and then see how many of those issues are talked about six months later – or six days later. Investors need to stay focused on their long-term plan and not be scared out of the market by short-term events. Remember: media exists to sell advertising – sensationalism sells.
Mistake No. 6:
Choosing an Investment Simply by Historical Returns
Investors often select mutual funds in a retirement plan or investment account based on how they performed over the past several years. There are several reasons why this mistake keeps happening. First, that superior performance may have been due to certain stock selections that just happened to be really profitable, or a particular market condition that no longer exists. That’s now in the past, and no help for the future. Additionally, the manager who did all that great stock-picking may have left the fund for a better deal somewhere else based on their great performance. So a fund’s track record alone isn’t enough. Investors need to consider what type of stocks the fund invests in, who the managers of the fund are, what the expenses of the fund are, the style of the fund, and what the stipulations of the fund are in the prospectus.
Mistake No. 7:
Not Having a Goal
Ask any number of investors what rate of return they expect on their investments, and their answers sound something like, “Uh, I guess I want them to grow as much as possible.” This mistake creates a situation where an investor never knows if they have achieved their goal. Investors can avoid this mistake by knowing what they expect their returns to be over a certain period of time. For example, let’s say that you have decided that you need your money to double in value 12 years from now. To achieve that goal, your account would need to average 6-percent growth per year. This target helps you to decide what to invest in, how to mix up your investments, and lets you know if you are on track. If you know that you are on pace for that rate of return, market declines will be much less worrisome and the urge to “get out” will be easier to avoid.
Mistake No. 8:
Getting Your Advice From the General Trough
There are lots of people in the media handing out specific financial planning and investment advice. However, that advice is often general in nature and provided without any knowledge of a particular investor’s specific individual needs, desires, or any other unique factors. Knowing any or all of these extra pieces of information might change the recommendation that is being presented on the TV or computer screen. General advice, such as the rules for contributing to an IRA account, can be very helpful. However, specific advice as to whether you should convert an IRA to a Roth-IRA requires knowledge of your individual situation.
Mistake No. 9:
Following the Herd
When markets have been rising over several years, the urge to “get in” or to put more money into investment accounts can be strong. Conversely, when markets are declining, the urge to pull out or move to cash can be even stronger. These impulses can be made even more intense when it seems that everyone else is doing them and that you might be left out of a market rally or be stuck in a market decline. Long term-investors who want to achieve their goals may want to avoid both.
Mistake No. 10:
Comparing Your Overall Portfolio Returns to the Stock Market
Although it is customary to use the S&P 500 or Dow Jones Industrial Average as a proxy for U.S. stock market returns, it is not a good way to compare portfolio returns. Why? Because most investors should not be entirely invested in the stock market. Just as one would not wish their portfolio to drop as considerably as the stock market when there is a major correction, they should also not expect it to rise as much in times of prosperity. This is the thesis behind asset allocation.
Robert C. Henderson is the President of Lansdowne Wealth Management in Mystic, CT. His firm specializes in financial planning and investment management for individuals approaching retirement or already in retirement, with an added focus on the particular needs of women that are divorced or widowed. He is an Accredited Asset Management Specialist and a Certified Divorce Financial Analyst. Mr. Henderson can be reached at 860-245-5078 or bhenderson@lwmwealth.com. You can also view his personal finance blog at http://lwmwealth.com/blog and the firm’s website at http://www.lwmwealth.com.
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