Most of us have a superiority complex and think we can outperform the market, even though most investors fail to do so. Passive indexes trounce the average investor. The average investor had a return of 3.79% and .72% in fixed income investments over the past 30 years, according to the DALBAR Quantitative Analysis of Investor Behavior Report. Over the same period, the S&P 500 rose 11.6%.
Investing Mistakes To Avoid
- Investing Mistakes #1 : Trying to Time the Market
The biggest mistake investors make is trying to time the market. To do so, you need to be able to predict the timing and future direction of prices. During volatile markets and corrections, investors do even worse when they try to buy and sell their way out of market mayhem. Such defensive trading during the October 2008 crash led to an average loss of 24.2%, according to DALBAR.
In contrast, investors who use dollar cost averaging enjoy superior investment performance. Dollar cost averaging is the investing of a fixed amount at periodic intervals. The investor avoids guessing whether the market is at the top or bottom. Over time, the returns smooth out. Investing in an employee retirement plan can be a form of dollar cost averaging if a fixed amount is taken from your paycheck at regular intervals and invested.
- Investing Mistakes #2: Emotional Trading
Another advantage of passive investing is that it takes the emotion out of trading. Fear is the emotion that most often interferes with trading performance. Active investors put themselves under a lot of stress, and traders under stress do not perform as well. Active traders are motivated by the reward system in the brain, which activates similar behaviours to those of the addictive personality. When we associate a reward with a goal, we place more focus, concentration and energy on achieving it. These responses contribute to our becoming obsessed with achieving the goal.
A smart trader, on the other hand, knows when to cut his losses and exit a position. The reward system is strongly incentivized to keep trying to obtain the goal. Index funds and dollar cost averaging are effective antidotes to emotional trading. Whether or not you have natural discipline as a trader, they will turn you into a disciplined trader.
- Investing Mistakes #3 : Active Investing
Passive investment strategies continue to outperform active strategies. As mentioned earlier, timing the market is tough and few investors are successful at. Moreover, active investors employ the best portfolio managers and must command higher fees to pay for their investment expertise and the trading fees to move in and out of stocks. Passive funds, on the other hand, track an index for a low fee. If you had invested in an index that tracked the S&P 500 six years ago, you would have tripled your money.
If you like the idea of trying to beat the market and feel you can do what only about 25% of investors achieve, then allocate a small portion of your portfolio to active managers. Place the rest in diversified index investments. High fees also seem to affect fund performance, possibly by adding more stress. Morningstar has launched the Active/Passive Barometer report to help you gauge the performance of active versus passive fund managers. The lowest cost large value funds performed 28 percent better than the category average, whereas the high-cost funds did only 18.6% percent better, found Morningstar.
- Investing Mistakes #4 : Single-stock Concentration
Over 50% of investors are invested in a single stock. Needless to say, the concentration risk is high. The stock is often employer stock. More employees are receiving stock options as part of their pay packages. Younger companies, often in the technology sector, are more apt to use stock options, which adds, even more, risk. Many investors delay moving out of their stock because of the complexity of options before them.
Investment advisors are sometimes accused of making choosing investments too complex. One single-stock diversification strategy is to diversify across index funds or exchange-traded funds (ETFs). These funds are low fee and tax efficient. Index funds take away the decision-making task while providing broad diversification.
- Investing Mistakes #5: Lack International Exposure
International and emerging market funds provide an opportunity to add some upside to your portfolio. Broad diversification is the best strategy in international funds. Also, stick with a conservative theme. Index funds doing well globally are those that are investing in leading companies. Depository receipts and exchange-traded funds are good investment vehicles. Additional risks in global markets include currency exchange, political and economic risk, lower liquidity, and less strict securities and accounting regulations.
- Investing Mistakes #6 : A Short Time Horizon
Long term, buy and hold investors do better over the long run. It is also important to match your investment strategy and instruments to your goals. If your goal is to save for retirement, you may decide to invest in a target-dated fund for 30 years. If a sub-goal is to pay for your son’s college education, you may choose an annuity that matures in 15 years when he is ready to enter college. If you should die before then, your son can still receive the college education funds as the beneficiary of your insurance policy.
- Investing Mistakes #7 : Failing to Rebalance the Portfolio
Especially in today’s more volatile markets, your portfolio can easily be redistributed away from the initial allocation goals. Periodically rebalance your portfolio to achieve your target allocation. This is also a good time to sell stocks that are not doing well and reinvest in winning stocks or sectors.
Investors are learning to be more disciplined. The retention rates of investors in funds has risen to four years on average. Most common investment mistakes can be rectified by putting your superiority complex aside and letting passive investing vehicles do the work for you.
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