Investors are their own worst enemies sometimes. As market participants, we often struggle with the pitfalls of fear and greed. These two emotions have the potential to inflict more damage to a portfolio than anything found lurking in economic reports or quarterly conference calls. However, beginners can mitigate risk by avoiding some common mistakes.
The cost of having emotions play a role in your portfolio is expensive. According to DALBAR's latest Quantitative Analysis of Investor Behavior, the average investor earns significantly less than major benchmarks. Over the past 10 years, investors in equity funds earned an average of 5.9% per year, compared to an average gain per year for the Standard & Poor's 500 of 7.4%. The gap is even larger when looking at the previous 20 years. Sensible investing strategies, such as dollar-cost averaging, can contribute to this performance gap, but imprudent action is still far too common.
"Through QAIB, we have learned that the greatest losses occur after a market decline. Investors tend to sell after experiencing a paper loss and start investing only after the markets have recovered their value," explained the report. "The devastating result of this behavior is participation in the downside while being out of the market during the rise."
Let's take a look at five rookie investing mistakes that should be avoided.
1. Investing before you are ready
Daily advertising tells us that we should start investing immediately in order to give our investments more time to grow. However, there are a few basic steps people should take before walking down Wall Street. You need to make sure you have saved up an emergency fund of at least a couple months of expenses. This should be kept in a readily accessible account, something boring like a savings account. The liquidity will help ensure you aren't forced to conduct any unwelcome selling in your investment portfolio.
High-interest debt should also be paid off before you begin investing. If you're carrying around credit card debt with an interest rate of 15%, the national average, you can essentially make a 15% return (risk free) by devoting your dollars to the debt, instead of stocks. The one exception that is widely agreed upon: If you have a 401(k) plan with an employer match, you should take advantage of the free money as soon as possible while you build your savings fund and pay down debt.
2. Not having a plan
You need to know why you are investing. In other words, what financial goals do you want to accomplish with your money? These vary among different people, but your financial goals should be clear, measurable, and attainable. They should also recognize constraints.
Without a plan, investors risk being lured into flavor-of-the-month investments. Far too often, investors will rush into funds with the highest rating — after the over-sized gains have already been realized. As the chart above shows, funds tend to underperform their benchmarks after receiving high ratings. In fact, five-star rated funds from Morningstar have the biggest gap over 36 months following the high rating.
Individuals shouldn't worry about every headline they come across on a daily basis, but they should take some time to review their portfolios throughout the year. On a semiannual or quarterly basis, make a 30-minute appointment with yourself or spouse to consider how your portfolio is performing and if you are on track to meet your financial goals
3. Trying to time the market
Unless you're a day trader, you should not be trying to time the market. With the rise of smartphones and tablets, investors are constantly plugged into financial markets, but that doesn't mean you should always be doing something with your portfolio. The Average Joe is typically better off with a diversified portfolio built for the long term. Trying to time the market can be disastrous, especially when it comes to stocks.
As the chart above shows, $10,000 invested between Dec. 31, 1993, and Dec. 31, 2013, would have grown to $58,332 if it was constantly invested in the S&P 500. If you missed the 10 best days during that period, the investment would have grown to only $29,111, almost half of the amount if you simply left the money untouched. Critics rightly point out that missing the worst days in the market is even better for a portfolio, but that is a dangerous strategy for most investors.
Even if you rightly time the market and avoid the worst days, you are then left with the agonizing decision of when to get back into the market. You need to know yourself and your limitations when investing.
4. Expecting too much
The past few years have been extraordinary for the stock market, but investors need to make sure their long-term financial goals don't depend on lofty expectations being sustained over a long period. Since the Dow Jones industrial average made its low of 6,470 on March 6, 2009, the index has rallied about 10,000 points. It has also managed to rally for five consecutive years to make fresh inflation-adjusted highs. The S&P 500, which also made its record low of 666.79 on March 6, 2009, has surged more than 170% over the same period.
This type of performance is not typical. Between 1926 and 2012, stocks have an average annual return of nearly 10%. However, inflation-adjusted returns are only 6.7%. Depending on your tax situation, stocks have returned 4.5% after taxes and inflation. Cash is the worst place to be over the long term, as it has returned only 0.5% after inflation and a negative 0.8% after taxes and inflation. Bonds have returned 5.4% over the same period, but only 2.3% after inflation. Distorting the results even more, bond returns are skewed by their thirty-year bull market that drove interest rates straight down to all-time lows.
5. Making investments more complicated
Humans have a tendency to make life more complicated than necessary. The same is true about investing. There is already plenty of risk that comes along with investing, but many people complicate matters by using leverage.
"When leverage works, it magnifies your gains. Your spouse thinks you're clever, and your neighbors get envious," explained Warren Buffett in his 2010 shareholder letter. "But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade — and some relearned in 2008 — any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces zeroes, even when it is employed by very smart people."
Leveraged exchange-traded funds are a relatively new financial product that most long-term investors should avoid. They are like regular ETFs laced with greed and impatience, and attempt to deliver multiples of the performance of an underlying index or benchmark they track. Leveraged ETFs seek to magnify returns by using some of Wall Street's favorite financial drugs: derivatives, futures contracts, and swaps. They can also come with higher fees. When it doubt, keep your investing strategy simple and steer clear of complicated vehicles that are more designed to benefit the people selling them.
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